InvestMacro

The mood in Europe continues to sour as stocks sell off and bond yields touch new lows in the Eurozone, with a hard Brexit on the horizon. While (Brexit) deadlines are there to be broken, the threats and counter threats by the UK and EU have ramped up today with a supposed request from PM Johnson to meet with his German and French counterparts being turned down.

The market has got tired of the ‘he said, she said’ headlines and is selling GBP aggressively. EURGBP has just broken through 0.92 to levels not seen since September. This means a major Fib level from the March high to low move around 0.9182 has been pierced. A strong close here and the bullish momentum may carry us to the September highs around 0.93. This looks like major resistance as prices have struggled to stay above here on numerous occasions over the past few years. Again, we should be aware of gapping risk over the weekend and into the Asian session on Monday.

EURUSD steady after ECB meeting

Traders have also been reviewing yesterday’s ECB meeting which, after all the hype, was frankly rather dull! Unlike in previous times under Mario Draghi when the bank would ‘never pre-commit’, the recalibration of policy instruments was well flagged and President Lagarde duly delivered a balanced, conservative package of measures, in effect handing over the baton to EU governments. That said, it was the first time the 2023 economic projections had been released and they showed inflation, even in the upside scenario, still be well below its 2% target. Surely that means there is more monetary policy easing to come?

President Lagarde’s verbal intervention of watching the exchange rate ‘very carefully’ is probably not enough to stem the ascent of EURUSD in the meantime. The ECB is certainly not cutting rates yet and it seems were it not for the threat of a hard Brexit, the world’s most popular pair would be nearer 1.23.

Euro strength to dampen Dollar index

With better news from the EU summit with the approval of the EU budget and Recovery Fund, the Dollar Index is languishing around it recent lows as Congress continues to wrangle over the bi-partisan stimulus bill. EURUSD looks to be forming a bullish flag pattern which should see prices higher if bulls can break last week’s high around 1.2177. This should push DXY towards 90.

UK Prime Minister Boris Johnson has issued a warning asking his side of the English Channel to prepare for a hard Brexit. Despite the warning, GBPUSD is still managing to hold around the 1.33 mark.

The binary outcome (deal or no-deal) is on a knife’s edge, which potentially sets the Pound up for an outsized move once the Brexit saga reaches its conclusive finale.

The fact that Sterling hasn’t yet capitulated against the US Dollar indicates that there’s still enough pent-up hopes that a Brexit trade deal will be secured before the Dec 31 deadline. There are also reports of a contingency plan being drafted in Brussels that would maintain air and road connectivity between the UK and the EU. Such measures, if enacted, are expected to blunt the economic fallout from a no-deal Brexit. That’s also being perceived as limiting Sterling’s immediate downside.

Pound weaker against most major currencies

To be clear, Sterling has weakened against all of its G10 peers this week, while also posting a week-to-date loss against all major Asian currencies. Amid fading hopes of a Brexit trade deal, the Pound has clearly ceded ground to the rest of the FX complex.

The worst-case scenario of a no-deal Brexit risks the Pound erasing much of the 4% gap that currently sits between current levels and its 200-day simple moving average, over the coming months. On the flip side, a last-minute deal could see cable breaching the long-term resistance level of 1.35, though the runway to the upside appears shorter compared to the downside.

Euro enjoying gusts of tailwinds

The Euro, on the other hand, is expected to fare much better in the event of a no-deal Brexit. With such a narrative in mind, no surprise that EURGBP strengthened by 1.26 percent on Thursday, registering its biggest single-day advance in three months. The Euro’s fortunes have also been aided by the bloc’s approval of its US$2.2 trillion stimulus plans, after overcoming resistance from Hungary and Poland, along with the ECB’s comments suggesting that the central bank may not need to deploy all of its policy firepower.

Still, a last-ditch Brexit trade deal could unwind some of those gains in EURGBP, while a no-deal outcome could send the currency pair surging towards 0.93 in the immediate aftermath.

US fiscal stimulus developments remain key driver over risk sentiment

Besides the gripping developments surrounding Brexit’s final chapter, global investors are also monitoring developments surrounding the next round of US fiscal stimulus. The futures contracts on the S&P 500 and the Dow Jones indexes are edging higher, as these US benchmark indices attempt to end two consecutive days of losses. Asian stocks are a mixed bag at the time of writing.

Thursday’s release of the US weekly jobless data shows a disturbing uptick in the initial and continuing claims. Coupled with last week’s underwhelming November non-farm payrolls print, such unsettling readings of the jobs market should really light a fire under squabbling politicians and get them to roll out more financial support for the economy. Otherwise, the US risks bearing permanent scars that could really hobble its ability to move into the post-pandemic era.

Should a US fiscal stimulus deal be agreed to by year-end, that could set the stage for a Santa rally and propel equity benchmarks onto new record highs.

Such ambitions could also be buffered if the respective Covid-19 vaccines by Pfizer and Moderna are green-lighted for emergency-use application by the FDA in the days ahead.

The long-awaited talks to end all (Brexit) talks failed to provide a breakthrough after last night’s high-level dinner meeting between PM Johnson and European Commission President von der Leyen. ‘Very large gaps remain between the two sides’ and a final Sunday deadline has been set for a ‘firm decision’ on any potential deal.

Sterling has tumbled 0.7% with EUR/GBP pushing above 0.91 earlier in the session.

The UK’s currency has been buffeted by political developments over the past few days as traders try and work out if even a ‘lite’ deal can be agreed. The optimists hope that the two sides negotiation teams can still get to this point and that the new deadline might be extended if the UK and EU are close to agreement. But hopes are certainly fading as this would need to be ready to verify by the EU Council before the end of the month. Betting markets now have no-deal chances at 53%.

At least agreement is largely expected at the EU Summit with approval of the EU budget and recovery fund, after Poland and Hungary agreed a compromise with Germany. As for the ECB meeting shortly, President Lagarde has already pre-committed to easing which will likely be seen with more bond buying and an extension of bank loans. This probably won’t be enough to push EUR/USD lower and outweigh the bearish USD forces currently in play.

EURGBP pushes north

The trade weighted EUR is close to its four-month average which is important to note for the ECB watchers who may be disappointed by any lack of jawboning by the ECB today. But Brexit is driving EURGBP higher and prices are now trading above the 50% retracement level from the March highs and lows earlier this year.

If the pair can hold above 0.91, then bullish momentum can push prices towards 0.9161 which is the next major Fib level.

This year, the Euro has been one of the best performing major currencies, having appreciated 8% against the Dollar so far while rebounding 14% from the March lows. The rise in the Euro has come despite depressed bond yields across both the core and periphery economies, in which Portugal’s 10-year yield was the latest to fall below zero last week.

The latest lockdowns and an unknown Brexit outcome will only add further pressure on economic growth in the final quarter of the year and possibly well into the first half of 2021. Having a higher exchange rate in such circumstances puts further pressure on inflation and make exports from the bloc less competitive. On the bright side, a vaccine is arriving soon but the positive impact will only be felt in the long term.

This leaves the ECB in a tricky position as the Governing Council needs to decide whether to go all in with more monetary stimulus or take smaller steps to address current risks. The bank is expected to increase its emergency asset purchase program (PEPP) by another €500 billion to a total of €1.85 billion. That would keep yields across the bloc in check and possibly drag them a little further despite the rise in debt levels. However, without some form of yield curve control, investors know that the ECB’s actions are really just delivering the same outcome. This is likely to keep financing conditions loose but is not enough to meet the mandate of an inflation rate just below 2%. A stronger Euro is again to blame.

For the ECB to push the Euro lower, bolder action needs to be taken. The €500 billion increase in asset purchases is already priced and won’t curb the currency’s strength. Verbal intervention to talk down the exchange rate may last for hours or a couple of days but is not a long-term solution. The only game-changer is to deliver a surprise deposit rate cut and add more than €500 billion to the emergency asset purchase program. However, the chances of this happening are extremely low, especially as the ECB hawks will stand firm against such measures.

Christine Lagarde knows that monetary policy alone won’t be the answer to boosting inflation back to target levels and that comprehensive fiscal action is needed. It is highly significant then that the two-day EU summit kicks off today and we may learn if and when the new recovery fund will see the light.

The Euro’s fate over the next several weeks hangs on external forces. A failure in EU–UK negotiations in which Britain exits the bloc without a deal would lead to a big selloff in the EURUSD, but of course a steeper one in Sterling. Delivering a smaller than expected US stimulus package could be another factor, but the impact would be smaller. A third factor could be the resumption of the selloff in global equity markets triggered by US tech stocks, as we saw yesterday. Any sign of a steeper correction in equity markets is likely to provide a boost to the US Dollar.