Shifting BoE tone raising chance of further GBP declines

The pound has been hit hard over the past four months, with GBP/USD falling back into the critical $1.2435 support level. With just months until the UK is expected to leave the EU, the way that the following months play out will be hugely important for the UK economy and in turn, financial markets. The pound has been the key barometer for market expectations of a no-deal Brexit, with the rise and fall of that eventuality being one of the key determinants of how markets have priced the pound.

Brexit fears driving slide in business confidence

Today has seen Richard Branson provide the latest in a long list of business owners who warn of the dangers a disorderly exit from the EU would pose to firms in the UK. There is no doubt that should the UK leave without a deal it would bring huge disruption to UK business. However, with the UK economy showing signs of a sharp slump ahead of the October Brexit deadline, there is also a huge issue emerging of business confidence and a subsequent lack of investment. For the most part the issue lays within physical goods, with the trade of services expected to be a somewhat less problematic area.

Governer of the Bank of England (BoE) Mark Carney’s comments released within the financial stability report today points towards a financial sector which remains resilient enough to weather the effects of even the worst case form of Brexit. However, while the services sector remains marginally within expansion territory, the declines we are seeing elsewhere are likely to drag UK growth lower. The graph below highlights the declines evident in manufacturing/industrial business confidence, with output across the economy falling in response. Unfortunately, with another three months until the Brexit deadline, fears over the potential for a no-deal Brexit are unlikely to go away soon.

Will Carney change direction?

With the UK economic picture on the slide, and the threat of a no-deal Brexit growing by the day, the difference in monetary policy expectations provides one boost for the pound. While Carney previously stated that the BoE would look to raise rates even in a no-deal scenario (GBP weakness drives inflation higher), we are now seeing tentative signs that the BoE would cut rates in such an event. That is a significant shift, and with markets now pricing in a 48% chance that there will be a rate cut by January, the question is whether that could be the first of many such cuts if the UK leaves the EU without a deal. We are yet to see Carney truly lay out a willingness to cut rates, and markets will be very attentive to any appearances he makes.

With the new leader appointed just three months before the October Brexit deadline, there is going to be a substantial degree on anxiety even beyond this leadership battle. Thus we have the potential for a triple whammy of a growing chance of a no-deal Brexit, deteriorating economic data, and rising expectations of a post-October rate cut. With that in mind, further downside looks likely for the pound.

Sterling remains at risk despite rise

The weekly chart highlights the recent breakdown below trendline support, with price subsequently moving into the $1.2435 December low. A break below that level would bring about a new two year low. For the near term, we would need to see that level overcome for the declines to ramp up.

However, given the rebound we have seen over the past two days (thanks to Federal Reserve chairman Jerome Powell's testimony), it looks like we could be in retracement mode for the time being. A break through $1.2784 would bring a wider bullish outlook, yet until that happens it looks likely we are retracing the $1.2784-$1.2439 sell-off. With that in mind, further gains towards the 61.8-76.4% zone ($1.2654-$1.2702) would look like a good selling opportunity.