The British Pound's Latest Brexit Surge Could Signal The Next Sentiment Change

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Summary

British Secretary David Davis suggested the UK is preparing for a "soft" Brexit.

The resulting swift surge in the British pound had no staying power and may have indicated early stages of exhaustion in the relief rally.

The move also seemed to validate trading against the euro as the best indicator of market sentiment on the pound.

Before Thursday's open for trading in the U.S. (December 1, 2016), the British pound (NYSEARCA:FXB) experienced another one of those "quick trigger" moves in reaction to Brexit-related headlines. I use "quick trigger" to describe a response that is so strong and rapid that it is likely bigger than the importance and/or conclusiveness of the news. In this case, it was commentary in a governmental session that motivated the market. According to the Daily Telegraph, Brexit Secretary David Davis declared that "…Britain would consider making payments to the EU budget in return for access to EU markets." This comment came in response to a question from Labor MP Wayne David about the government's willingness to make any kind of contribution to maintain access to the European single market.

The market's response to a mere comment was strange in that the comment did not represent a final decision. The comment was not linked to the conclusion or even launch of any negotiation with the EU. So, I have to assume that the resulting swift strength in the pound came from the springboard of an abundance of pessimism that is prone to spasms.

The chart below shows how fast the currency market responded to this prospect of a "soft" Brexit…and then reversed itself.

Davis helped drive the pound against the euro, but the move was not sustained.

EUR/GBP dropped until the open of U.S. trading. At that point, EUR/GBP tested support at its 200-day moving average (DMA). This line of support has held for a year through two previous tests which occurred a few weeks before Brexit and right after Brexit. I suppose this latest test helped motivate the return of cooler heads. The subsequent reversal was 100% complete by the close of U.S. trading. I think this successful test of 200DMA support confirms and validates my claim from early November that the pound's trading against the euro (NYSEARCA:FXE) is a better indicator than its trading against the U.S. dollar (NYSEARCA:UUP) for pound sentiment.

EUR/GBP looks like it topped out in October. The next question is whether the critical support from the uptrending 200DMA can continue to hold.

Source: FreeStockCharts.com

The pound's reversal took GBP/USD from a breakout that would have confirmed the recent bounce from support at its 50DMA. A breakout at this level would also complete the reversal of the loss from the pound's "flash crash" on October 6th. (The pound reversed its flash crash loss on EUR/GBP in early November).

GBP/USD is trying to confirm support at its 50DMA as part of a slow bottoming process.

This episode reinforces to me that one of the market's biggest anxieties about the British pound is the prospect of economic damage from reduced trading with the European Union (NYSEARCA:EU). The rapid reversal suggests that the source of (short-term?) buyers may finally be drying up. Accordingly, I have further increased my hedge against my long positions on the British pound to reach neutral, perhaps even slightly bearish. I will be watching the follow-through in EUR/GBP for clues on how to adjust the hedge in coming days (with some allowance for the coming election in Italy).

In the meantime, I have duly noted that speculators continue to retreat from net short positions very slowly. Current levels remain extremely high relative to previous run-ups of bearish sentiment since 2008. In other words, speculators are still not too concerned about the pound's current relief rally and the volatility along the way.

Net shorts in the British pound have pulled back slowly but surely in recent weeks. Still, current levels match levels last seen, prior to 2016, in the summer of 2013.

Source: Oanda's CFTC's Commitments of Traders

Be careful out there!

Disclosure: I am/we are long FXB.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: In forex, I am net neutral to slightly bearish on the British pound