GBP down but not out ahead of Article 50 as Trump given second chance

The pound was the weakest performer in the G10 on Tuesday and has dropped below 1.24 as Article 50 fears and the prospect of a second Scottish Referendum start to bite and the dollar roars back to life. This could be a case of sell the rumour, buy the fact, and we stick to our view that sterling can brush off Article 50-inspired weakness and that sterling is essentially range bound as we formally kick off the process to leave the EU.

Focus switches to Trump’s tax plan

It’s worth pointing out that the pound actually rallied when Downing Street announced the date of the triggering of Article 50 last week, and the prospect of a second Scottish referendum didn’t impact the pound when it was first touted a couple of weeks ago. Thus, these events are not the key driver of the pound right now. Instead, we believe that the dollar recovery will be more important for the pound in the coming days. The dollar index jumped by more than 0.5% and US stock markets closed higher for the first time in four days on Tuesday. The markets are rallying, which is a sign that they are willing to trust Trump again, as his policy team switch to tax reform after their failure to get their healthcare bill passed by the House of Representatives at the end of last week.

Longer-term risks to the pound more of a worry  

While I am not convinced that Article 50 – a mere formality – is likely to weigh heavily on sterling in the coming days, I am concerned by the rise in the 1-year GBP/USD risk reversal. This is a commonly used measure of volatility, and it has risen to its highest level since Autumn 2015, when then Prime Minister David Cameron announced that an EU Referendum would be held. This rise in longer-term volatility is a sign that the markets are not convinced that Brexit negotiations will go well, and are hedging their bets when it comes to sterling. Looking ahead it is not Article 50 that should concern the markets, but rather the response from the Europeans. Two dates to watch out for include: 4^th April and 29^th April, when the EU’s response to the UK’s triggering of Article 50 and the first EU Brexit summit take place, respectively. This should give the market a sense of the tone of the negotiations, and whether the EU will want to work with the UK to give them a good deal, or if they want to punish them for deciding to leave. Obviously, the latter would be a big negative for the pound. Regarding the second Scottish Referendum, this is likely to be 1.5 to 2 years’ away, so this is tomorrow’s problem for the markets.

Why Article 50 could trigger more weakness for the FTSE

The Trump trade helped to lift equities across Europe on Tuesday, although it is worth pointing out that the FTSE 100 was the weakest performer out of the major European indices. There also was some Brexit-related weakness in certain sectors, including real estate, which could be vulnerable to a weakening financial sector and a reduction in EU immigration. Consumer staples also bucked today’s uptrend, possibly because this sector acts as a safe haven, but also because Brexit-related inflation could hit consumption in the coming months and years.

We mentioned last week that the second wave of the Brexit trade could see the FTSE more impacted than sterling, as the detail of how Brexit will impact UK business is made known, and investors start to price in any negative impact from us leaving the EU.  Interestingly, the FTSE 250 had a positive session on Tuesday, further adding to evidence that today’s dip in sterling was not only about Brexit-related fears, and instead a sign that the market is once again embracing the Trumpflation trade.

A vulnerable rally, but a rally nonetheless…

A quick word on Trump and the markets, we had noted the pick-up in the lead indicators on Monday, including the Dow Jones Transportation Average, which suggested a market recovery was possible. The Transportation index rallied further on Tuesday, and closed the session testing the 100-day sma, a key level of resistance. If buying pressure can push this index above 9,121 on Wednesday, this would be a bullish signal for the broader US markets.

At the time of writing, futures markets are pricing in another positive open for US and European markets, while the pound has managed to find some stability around 1.2440. Whether or not the market will buy the pound once Article 50 is triggered, we will have to see. How far sterling could recover is likely to depend on wider market sentiment, The market is willing to give Trump a second chance, but if he can’t get Congress to agree to his plans for tax reform then we could see markets lose faith once and for all. Although economic data continues to strengthen in the US, the markets are still sensitive to Trump and his legislative plan for his term in office, thus this is a vulnerable rally, but for the moment it is a rally nonetheless.