Rock Bottom And Negative Stability - How Sterling Falls

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Summary

Will it go lower?

The last major drop in the pound-dollar exchange rate began around the time of PM Theresa May's announcement that Brexit meant Brexit.

How the U.S. election result will affect the future of USD/GBP.

Recently, the popular comedian and political commentator John Oliver observed of the acrimonious marathon slugfest to become the next U.S. President, that rock bottom was a place which had long since been left behind. While humour was the purpose of his commentary, a more serious point lies just beneath its surface. John Oliver comments on the U.S. election. Source: HBO: Last Week Tonight

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GBPUSD 1 Month. Source: Xe.com

If it has become impossible to determine the potential nadir of debate, the question has changed. Perhaps we should no longer speculatively ask how low can it go. The more appropriate question might now be binary. Will it go lower? Of course, almost every reasonable answer has its ifs and buts, its stabilising factors, and potential causes behind which to rally, but the more we adapt to a climate of incremental lows, the less the highs appear good news, and the more they seem merely to be the last gasps of the canary. What is interesting here is the market parallel. While the market, despite some signs of turning, broadly seems to remain on a bull run, there are some trades to which the more serious undertones of Oliver's joke apply. The recent up-tick in sterling after deep lows may be one such example. This brief rally, following the so called Flash Crash seems much more like a gasping canary than it does a currency stabilising at a new base level.

GBP/USD 1 Week. Source: Xe.com

There is, of course, a case for suggesting that the $1.21 to $1.23 mark might be a level around which the [GBP] [USD] exchange rate could stabilise. However, every prediction of stability comes with that dangerous caveat, unless there is a significant change in circumstances. As former British PM Harold Macmillan once said: 'Events, dear boy events.' With the next quarter almost certain to be eventful, the $1.21 mark seems unlikely to be that line in the sand which shall not be passed. Will it go lower? Events permitting, in the medium term, it looks likely.

The last major drop in the pound-dollar exchange rate began around the time of PM Theresa May's announcement that (Brexit) meant (Brexit) and continued through to comments from France, which poured fuel on the fire of the idea of an EU set on an aggressive negotiating stance, and of course, the now-famous Flash Crash. More recently, the exchange rate has shown signs of stabilising at a new base level, and some small shoots of a rally are in evidence. The problem with this is whether this rally is based on a belief that the risk of future events has now been priced in, or whether it is simply a relief rally, one somewhat supported by more positive noises emanating from Britain.

There is certainly some relief in recent news. Lord Pannick QC, representing a legal case against the triggering of Article 50 without a full parliamentary vote, said that any attempt to do so would undermine parliament and 'deprive people of their statutory rights'. The court battle, should it be decided in favour of Lord Pannick's case, certainly increases the likelihood of a softer (Brexit), which would be good news for sterling. In addition to this, the recent posturing in the British cabinet, by amongst others Philip Hammond, suggests that there might remain some room for manoeuvre, a further positive for those with an interest in the struggling pound.

Philip Hammond, MP, neatly highlights divisions on (Brexit). Source: The Guardian

The trouble with these announcements, and their opposites, such as May's more recent confirmation that 'there will be no second referendum', is simply that they, at best, a prolong the period of political uncertainty, and at worst, are indicative of political "flip-flopping." This is uncertainty is one of three reasons that this article begins with the question: will it go lower? As long as there is significant doubt about the course being navigated, downward pressure on the British currency will exist. At once this encourages the short-selling of the pound and discourages longer-term speculation over an increasing valuation.

The Rise of Inflationary Pressures in the UK. Source: Pantheon Economics

The second cause for the belief that the pound is set to drop further than its already low levels against the dollar concerns fundamentals. Recent retail sales volume data suggests, according to Martin Beck, senior economic advisor to the EY ITEM Club, retailers may have had a 'last hurrah […] [a]s the impact of the depreciation in the value of sterling steadily passes through to consumer prices.' As consumers are hit by the falling pound and rising inflationary pressures, there is a risk of a domino effect creating a potential recessionary spiral. Put simply, it seems unlikely that market volatility will not have an impact on the spending patterns of the British consumer and thereby British business. Any likely drop in British output is sure to provide further negative pressure on the pound.

The third cause is political, both foreign and domestic. Domestically, aside from Brexit-related uncertainty, increasing pressure on the purse of the consumer will strengthen the claims of those, such as William Hague, who want to see rate rises, regardless of Threadneedle Street's retort that they would not 'take instruction on [their] policies from the political side.' In the longer term, in the event of Hard Brexit, a slump in living standards will aid those who might push a protectionist line, which is certainly bad news for business, and bad news for sterling.

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The slowing chances of poll error, Trump Vs Clinton. Source: RealClearPolitics

Away from Britain, with the U.S. election results certain to affect the [GBP]-[USD] exchange rate, the closer we get to a Clinton win, and as pre-election volatility abates, the more likely the historically typical rise in the value of the dollar becomes. As David Byler of RealClearPolitics notes, 'every day that Clinton manages to keep her current margin is a day in which Trump's ability to shift the race diminishes.' A Clinton White House is likely to allay fears of a protectionist dollar and strengthen the currency in both the short and medium term against the pound.

What is clear is this: sterling has dropped almost 20% on its TWI (Trade Weighted Index) since the Brexit Referendum. The economy is suffering, though not without some positive shoots such as the unemployment rate remaining steady at 4.9% and a 2.3% rise in wages. The effects of the Flash Crash appear to have run their course, and barring the unexpected, short-term trading in GBP against the USD is likely to be at a level of between $1.21 and $1.23, depending on market sentiment. This said, the unexpected has become the norm, and at present political uncertainties are the main driver for the pound-dollar exchange rate. Moreover, the sine qua non of price stability is confidence, and that is in short supply. Therefore, with some negative trading likely to occur in the coming days and weeks, the psychological barrier of $1.20 is again likely to be tested. With pressure on the pound coming from speculation, political developments, economic fundamentals, and the gut feeling that yes the pound can fall, it would seem risky to bet against the $1.20 level being breached yet again. The next time it does, the value of sterling might not climb back.

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The Negative Stability of the GBP-USD Pair. Source: economies.com

Can sterling fall? Certainly. Will it? If events take a turn for the worse, it seems likely to. Selling during what appears to be a relief rally, unless there is a sustained attempt at a recovery target of $1.25, potentially shorting the rally after the sale, and taking your position at the next likely point of negative stability, until a further rally seems the wisest approach.

(Mr. Oisin Breen: Technical Analyst at Accendo Markets)

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