GBP/USD Remains A Sell

by: Hedge Insider

While the pound's short-term, one-year interest rate differential has demonstrated some occasional improvements, the exchange rate remains non-supportive.

Further, the rate differential for GBP/USD remains negative. The combination of political uncertainty and negative-carry provides GBP/USD with a very strong headwind.

Sentiment does not yet appear to be shifting to the upside, while the moving averages remain firmly aligned and pointing to the downside.

The long-term low set in 2016 (after the initial Brexit announcement) of 1.19048 would appear to be a clear target for GBP/USD. Leading into 31 October, it should become clearer as to whether a bullish reversal is in order.

However, for the time being, GBP/USD remains a sell and a highly risky currency pair. While upside volatility could occur, any short-term rallies are likely to be sold, especially if the short-term yield differentials are unable to set higher highs (rather than lower highs).

Perhaps contrary to the prevailing view, I believe the pound's large downside to date has been a greater product of U.S. dollar strength than pound weakness. If we compare two charts below of the euro and the pound, both look similar in the sense that they are regularly chopping up and down.

GBP/USD Price Action:

GBP/USD Daily Candlesticks EUR/USD Price Action:

EUR/USD Daily Candlesticks (Charts created by the author using charting tools. The same applies to subsequent charts presented herein.)

The U.S. dollar remains strong as its rates remain strong relative to the rates offered by other major currencies. Nevertheless, the pound has indeed fallen in line with the continuing political uncertainty surrounding Brexit, hence EUR/GBP has strengthened consistently over many weeks:

Long-term EUR/GBP Strength As the chart above indicates (using weekly candlesticks), EUR/GBP has climbed consistently and is back to the long-term highs last seen in 2016 and 2017. At this juncture, further euro strength relative the pound seems likely, at least to the "equal high" of 0.92253 (illustrated in my chart above by the pink line).

The question remains though, where is the bottom - specifically more GBP/USD? First of all, it is useful to reconsider where the yield differential stands. Market-priced government bond rates are more useful than the underlying rates or forward guidance set or offered by central banks, as they are dynamic, often prove to be more accurate, and ultimately feed through into short-term borrowing costs that actual traders face.

GBP/USD Rate Differential The crimson line in the chart above illustrates the one-year government bond rate differential between the United Kingdom and the United States. The higher it is, the more favorable it is to own pounds in terms of dollars. I have highlighted (using the green-shaded areas) times whereby the differential has improved, in favor of the pound sterling.

The shaded "areas of improvement", it is interesting to note, have not been enough to support the pound measurably. Even as the spread improved greatly through June 2019, the price was mostly flat at best (actually registering a new low in that month of 1.2506). Since then, the yield differential has mostly fallen, with each rise in the spread being accompanied by rise in GBP/USD, but only with a lower high (no breaks to the upside).

Most recently, the spread has improved greatly, but once again, this is a lower high (currently -1.32%). Additionally, this more aggressive rise in the rate differential (last week; again, illustrated by the crimson line in the chart above), has been met with practically zero upside in the pound sterling on an exchange rate basis.

This suggests that not only is Brexit and the surrounding political uncertainty weighing on the pound more greatly than ever, but also speculative capital remains wholly disinterested. While some aggressive traders may be buying dips, the trend (even on a very short-term basis) remains bearish. The chart shows the daily moving averages are all pointing down (50-day in red, 20-day in amber, 9-day in green).

GBP/USD Moving Averages It is simply not worth attempting to be a hero here: the pound, in the author's view, will continue lower. Upside volatility is a possibility, but the trend is strong and negative, and the short-term rate differential between the U.K. and U.S. still remains negative, even if it is able to improve on a short-term basis. If the Bank of England is forced to lower rates further to support the economy, the rate differential could worsen even further.

If the pound does continue to fall, how much further could it fall? As everybody gets caught up in the day-to-day and week-to-week headlines, it is easy to forget that the Brexit announcement initially sent the pound to as low as 1.19048 (registered on October 3, 2016, as shown in the chart below).

GBP/USD Long-term Low I have drawn attention to this region in past articles, and my view remains bearish: GBP/USD would appear highly likely to meet 1.19048 over the near term. At this level, we must "retool". The current deadline for Brexit is October 31, 2019. In my view, GBP/USD will test (probably with some additional negative variance, i.e. fall under) 1.19048 between now and the end of October.

However, either before (or shortly after) any Brexit outcome, sentiment may shift, and then we will be able to better determine whether upside or further downside is in store.

After 1.19048 has been broken, ideally with some negative variance to the downside (so that short-term support can be first established), the next directional bias will need to be supported by relative expectations of the U.S., U.K. and European economies. This will determine whether the U.K. is likely to suffer even weaker FDI (which I touched upon in my previous article) and/or investment inflows, and/or lower rates (which could steer GBP/USD even lower than 1.19).

In any case, for now, the pound remains a sell, at the very least until 1.19048 is breached. And even then, more information is needed to confirm the potential for a bullish reversal.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.