FX Week Ahead – no reprieve for EUR and GBP, yet.

Much of the recent focus in the currency markets has been placed on the economic outperformance of the US and the natural assumption that the unrivaled tightening path by the Fed put and should put the USD head and shoulders above the rest of the pack. This has been exacerbated by the political woes hurting the EUR and GBP, thereby directing the market towards the greenback as the only viable option in today’s risk sensitive arena. Based on the latter perspective, any breakthrough in the EU’s battle with Italy to rein in their budget plans and with the UK on their impending exit could – or should – see some repricing of exchange rate levels.

Longer term fair value in EUR/USD is somewhere in the 1.2000-1.2500 area, while Sterling is closer to 1.4000 against the USD. This puts fair value in EUR/GBP close to where it currently stands, so offsetting current risks suggest there is unlikely to be much movement unless one or other of these material risks can be reassessed. Any bias towards a potential outcome is a pure assumption, and at the present time, it seems the market is reluctant to do so – in accordance with objective practice. We are therefore resigned to keeping our eyes on the headlines and any fresh developments, but as we saw last week, the volatility is far greater surrounding the Brexit saga, where the UK PM is fighting hard for support in the EU’s draft proposals on a withdrawal agreement.

Sticking with the Pound, last week’s round of cabinet resignations was the catalyst for losses which saw the USD rate drop back towards the lows seen in recent months. On this narrative, it seems the fear in GBP was more a function of an implosion in the Tory party rather than any specific developments in the Brexit talks. The fact that the deal as it currently stands was doomed to failure in parliament was largely factored in, and that there will be continued to and fro between the UK and EU before something workable can be judged to have any real traction. The PM herself has admitted – and did so during the commons session last Thursday – that this is not necessarily the final deal, and to that end, the ERG is now looking to approach the PM to try and facilitate some changes. As of Monday morning, they still do not have the requisite votes to trigger a leadership contest, which most political pundits still believe the current PM would win.

For now, the battle lines have been drawn for the Pound (Cable), where buyers ahead of 1.2700 are not ready to throw in the towel on any breakthrough. Given the upside potential based on the above fair value levels, it is not hard to see why. This leaves us to consider what developments could push the spot rate through the lows to test further demand expected in the 1.2500-1.2600 area, further testing the deviation from the mean (measured by fair value) as an effective risk premium.

In the meantime, EUR/USD is trading water above the 1.1400 mark, as we continue to assess whether what we saw last week was another false break below the 1.1300 mark.

As well as having the UK withdrawal to deal with, the (EU) commission are also digging in their heals on Italy’s budget spending plans. Italy’s intransigence is clearly being communicated through both Lega’s Salvini and 5-Star’s Di Maio, so we wait to see whether the EU will trigger the ‘excessive deficit procedure’, which has been implemented before, but with limited contagion risk. Italy is the third largest economy in the Eurozone, to the risks of taking such action are much higher in this case. With European elections next year, the EU has a balancing act in considering whether to inflame the wave of populism even further. If they exercise some leniency, then we expect this could go some way to alleviating some of the discount in the EUR, though any material upside traction will need bolstering from the data in the region. Deterioration is clearly unnerving the ECB, who as yet still consider this as temporary. A lower EUR and ongoing accommodative policy should help, though QE here ends at the end of the year and there is little sign that this will be extended as yet.

Technically, a break back over 1.1500 will tame bearish sentiment, though it will be a struggle to achieve this. If the Fed rein in their rate hike path to any degree, then we could see a push higher, though, 1.1600 and 1.1800-40 are even stronger levels to negotiate with the current backdrop in Europe.