EUR/GBP Likely To Favor Downside

The EUR/GBP currency pair, which expresses the value of the euro in terms of the British pound sterling, provides a glimpse into the relative confidence that the market has for the United Kingdom and the European Union. That is, confidence in both their economies and the governments overseeing these economies.

However, as we have seen recently in EUR/GBP, the pair can catch many off guard. In fact, it caught me off guard; my previous article covering EUR/GBP was unfortunately extremely poorly timed. I took a bearish view on the pair in late February, yet the euro was subsequently able to spike against GBP. The daily candlestick chart below illustrates the recent price action.

(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)

I felt that EUR/GBP would favor downside, as the bond market was fairly steady and perhaps seemed too nonchalant with respect to the potential for a negative variance in euro rates (via rate cuts). Although another rate cut could be on the cards for the European Central Bank, this has not happened as of yet.

On the other hand, my article does have one redeeming quality, in that I touched on the potential for a spike upward in EUR/GBP (in spite of my overall bearish thesis) given that EUR short positioning was already quite prominent. One of my comments was as follows:

What we are likely to see is further EUR outflows, but with short-term upside volatility as markets become more sensitive to the bearish story which everybody is becoming increasingly supportive of. When markets push too far in one direction, prices can become more sensitive as more leveraged positions can unwind (creating feedback loops which precipitate moves).

I noted that a short-term reversal to the upside was not off the cards, but that the fundamental backdrop favored downside (longer term). I still think the bearish case remains intact, as the relative fundamentals between the U.K. and Europe are largely unchanged.

The COVID-19 pandemic, which seems to have sparked many of the risk-off moves that we have seen recently, has battered currencies that the market views as being far out on the “risk-on” side of the FX spectrum. GBP is clearly on the far side of this spectrum; we can prove this by first looking to S&P 500 futures prices (a proxy for U.S. equity performance) and noting the recent high in February 2020. The subsequent drop created a ricochet of risk-off moves, including across the FX space.

S&P 500 Futures Performance in 2020

Using the date of February 20, 2020 (marking the recent high), we can take a look at some FX indices (for various currencies) to see how each currency moved (in each case, relative to a basket of currencies). The chart below illustrates this, in relation to this date.

FX Indices Performance Post 2020 Crash

Notice that moving into the so-called crash date, most currencies remained fairly subdued with respect to volatility. Volatility spiked as equities started to tank. EUR and JPY, two popular funding currencies, initially spiked as speculative and carry trades were unwound, before tailing off and remaining fairly range-bound. AUD, conventionally viewed as a commodity currency, crashed alongside GBP.

As one would expect, AUD performed the worst. However, GBP was not too far behind, and hence, the market clearly places the currency at the far end of the risk-on spectrum. The image below illustrates what this spectrum might look like for these select currencies (USD, JPY, EUR, GBP and AUD).

FX Risk Spectrum

In other words, we have the market bidding up USD and JPY in a risk-off environment, while EUR is often able to catch a bid via the unwinding of speculative trades funded in euros (as well as capital repatriation from USD back into EUR), while GBP and AUD get sold heavily during risk-off environments. On the other hand, during risk-on environments, we can expect any risk-off volatility in GBP and AUD to be unwound, favoring upside.

We have seen this recently, as equities have been stubbornly rising in spite of global economic risks which remain surrounding COVID-19 and the significant disruptions which have already produced a seasonally adjusted annual contraction in U.S. GDP of -4.8% in the first quarter of 2020. As equities have been rising, both GBP and AUD have found support. As AUD remains further out on the risk spectrum, it has been beating GBP, as we can see by taking a look at the GBP/AUD chart.

GBP/AUD Daily Chart

If there is another risk-off move, including a decline in equities, we would need to consider the possibility of another spike in EUR/GBP prices. However, it is likely that as significant risk-off moves “cluster”, the probability of a reactionary rise in the euro is likely to fall.

That is because the reactionary rise in the euro in response to crisis often comes from the unwinding of trades and capital repatriation (i.e., mechanical reasons, not fundamental reasons). After a sharp drop in equities, which we saw following February, it is unlikely that international capital flows would have moved so quickly back into the other direction (on the bullish side). Capital is quick to de-risk, but not necessarily so quick into risk.

Therefore, while EUR/GBP is still subject to spike upward on the back of new, risk-off driven volatility, any variation is likely to be softer than the recent rise. In other words, EUR may begin to favor downside independent of risk sentiment (and downside is indeed congruent with the euro’s long-term trend). This could mean we could see a shifting of EUR further to the right on the FX risk spectrum, to align more closely with GBP.

Should the stubborn risk-on environment continue, it is not difficult to see that EUR/GBP is likely to favor further downside, owing to the market’s perception of GBP in relation to risk. In another risk-off move, EUR/GBP might jump, but is unlikely to target recent highs above the 0.94 handle. The sort of “reactionary ammo” we saw recently takes time to build up, usually after many months of complacency. Another round of downside volatility is unlikely to produce such a sharp move, so the longer-term (bearish) thesis for EUR/GBP should remain intact going forward.

EUR/GBP Trading Range

The chart above illustrates the trading range from around 0.83 to 0.93 which EUR/GBP has settled within throughout much of the period from July 2016 to present. The price-volume analysis tells us, per the red line, the approximate level at which most trade has been conducted (per trading volumes), which is unsurprisingly in the middle of the range at roughly 0.88 (close to the current price of 0.8700-0.8750.

While there remains a risk of another bout of upside in EUR/GBP, perhaps even to the 0.91 handle, we should ultimately look for lower levels to trade. Long term, we should expect EUR/GBP to trade to the bottom of this range toward 0.83, with a longer-term break out of this range. This would, however, require a return to the growing optimism that was already being priced into GBP pre-COVID.

The recent crisis may have provided a shock to the pro-GBP thesis, but a gradual return to a less-volatile, less “mechanical” market should deliver downside pressure to EUR/GBP. Any rallies in EUR/GBP may offer interesting opportunities to sell the pair.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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