GBP/USD forecast: Brexit deal limbo leaves pound vulnerable

Pound sterling strenght hinges on Brexit deal breakthrough

• GBP/USD price action has spiked 300-pips since last Friday
• The sterling remains exposed without a Brexit trade deal
• Pound-dollar gains piggybacking on broad USD weakness

GBP/USD is the best performing major currency pair so far this week. The cable has climbed over 300-pips from last Friday’s close with the move looking fueled by a combination of pound sterling strength and USD weakness. GBP has gained considerable ground as the UK and European Union (EU) agreed to extend Brexit trade deal negotiations while the USD has faced renewed selling pressure on the back of progress made toward reaching a coronavirus aid package. These developments have pushed the pound-dollar to its highest level since May 2018.

GBP/USD price chart: daily time frame (10 August to 16 December 2020)

The latest influx of pound sterling strength has propelled spot GBP/USD price action to its upper Bollinger Band. Meanwhile, the relative strength index is approaching overbought territory again as forex traders attempt to front-run confirmation of a potential Brexit deal. This highlights potential for a retracement lower with the $1.34 handle in focus as an area of resistance-turned-support. A pullback by the pound-dollar could correspond with no deal Brexit risk resurfacing.

Breaching the $1.34 price level, which would likely follow a material breakdown in Brexit trade deal negotiations, might motivate GBP/USD bears to make a deeper push toward the $1.3225 mark. This area of technical support is roughly underpinned by a confluence of the 50-day simple moving average (SMA), lower Bollinger Band, and bullish trendline extended through the September and November lows. If GBP/USD price action takes out this possible area of buoyancy, it could open up the door to a sharp slide lower with the $1.28 zone in focus as a potential downside objective under a no deal Brexit scenario.

GBP/USD price chart with two-week risk reversal overlaid: daily time frame (17 December 2019 to 16 December 2020)

That said, looking to forex options trader positioning, it appears that markets remain dubious of a Brexit trade deal. This is judging by GBP/USD risk reversals, which show a reading of -3.20 for the two-week contract that emphasizes the 31 December hard Brexit deadline. A negative risk reversal reading indicates greater demand for put options (i.e. downside protection) relative to call options (i.e. upside protection). With cable call-put skew turning less negative over the last few trading sessions, however, the standing bearish bias maintained by GBP/USD options traders has waned.

This likely follows a positive shift in language about reaching a trade deal from Brexit negotiators such as Michel Barnier, the EU’s chief negotiator, who recently stated ‘some movement on both sides’ has been made, adding that there is a ‘narrow path’ for reaching an agreement. Nevertheless, with no deal Brexit risk still a possible outcome, particularly with the issue of fisheries a major outstanding point of contention, the two-week risk reversal reading for GBP/USD still hovers around peak pandemic lows printed earlier this year.

GBP/USD price chart with IG client sentiment overlaid: daily time frame (1 June to 16 December 2020)

Comparatively, retail forex traders have turned increasingly bearish on GBP/USD according to the latest IG client sentiment readings. Over the last week, pound-dollar client positioning with IG has seen a massive 20% increase in net shorts and -9% decrease in net longs over the last week. The latest IG client sentiment reveals a massive 20% increase in net shorts and -9% decrease in net longs over the last week. On balance, the positioning report reveals 31% of traders are net long GBP/USD. Seeing that we typically take a contrarian view to crowd sentiment, combined with the fact that traders are net short and have grown more bearish recently, spot GBP/USD price action may continue to rise.

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