Is it time to short the euro against the pound? While sterling has been on the defensive since the EU Referendum nine months ago, there may be signs that UK currency could be set for a recovery. On the other hand, sterling could be set for a tumble if Brexit negotiations turn sour. 

Short EURGBP?

 

The pound has lost about 13% of its value against the euro since June 2016. Positioning is still heavily short although the pound has enjoyed something of a rally since Theresa May’s hard Brexit speech in January, which indicates sentiment seems to be improving.

The prospect of a clean divorce is helping the pound. So far the language on both sides has been constructive, Gibraltar aside. The hope for a transition deal is supportive.

Barclays reckons that the pound will recover to its pre-referendum levels within the year. Morgan Stanley is also bullish, saying that GBPUSD will return to $1.28 by year-end and by $1.45 by the end of 2018. GBP is cheap in a historical context, they say, and short EURGBP is their favourite play.

The Financial Times reports that central banks are ditching the euro in favour of the pound. According to the figures from Central Banking Publications and HSBC, the pound is seen as a safer bet because of political risk and negative rates in the Eurozone. Given Brexit and the uncertainty it entails, it does seem counter-intuitive. However there is a sense that Brexit is priced in, while there are significant risks in Europe that are not fully acknowledged.

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GBP shorts

 

But the market is still heavily short on the pound. Data from the Commodity Futures Trading Commission's (CFTC) weekly Commitments of Traders (COT) report shows investors are net short sterling. Speculative net short GBP positions totalled in excess of 104,000 contracts at the end of March, although this was marginally lower than the record high hit the previous week.

Some argue that this is too crowded a trade. Given how cheap the pound is, there potential for a short squeeze. Equally, though, the pound is finding life tough and the risks of a messy Brexit raises significant risks to the downside.

 

ECB v Bank of England

 

Another factor for EURGBP is the central bank question: who is first to blink? Current noise suggests it will be Britain's central bank.

The Bank of England has started to pivot towards a slightly less accommodative stance. One member of the nine-strong Monetary Policy Committee voted to raise rates in March and others seem close to doing the same.

The case for tightening is based on rising inflation, which has been creeping up steadily since the autumn and is widely expected to be above the Bank’s target rate of 2% for some time. Indeed CPI roared ahead to 2.3% since that MPC meeting and there are some murmurings of the Bank raising rates.

The MPC minutes showed that “…some members noted that it would take relatively little further upside news on the prospects for activity or inflation for them to consider that a more immediate reduction in policy support might be warranted”. The spike to 2.3% might just be enough to get one or two policymakers to go for a hike, although markets don’t expect a majority to support tightening yet. Nevertheless there are clear signs that the MPC is not willing to tolerate an overshoot in inflation indefinitely, whatever the downside risks are from Brexit.

Meanwhile, the ECB has recently been talking down the prospect of tightening. After a rally for euro against the dollar, sources at the bank suggest that the Governing Council is further away from hiking rates or tapering than markets think.

That view gained added traction after a plunge in inflation. Core CPI – the key gauge for the ECB as it strips out volatile elements like fuel – slipped back to 0.7% in March from 0.9% the prior month. The headline inflation rate fell from 2% to 1.5%. That move seems to be vindicating the dovish stance from the ECB and its view that the recovery in prices is rather lumpy and not self-sustained. It all points to the ECB staying loose for longer.

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