- GBP/AUD closes in on 2-year lows

- AUD in the driving seat as commodity prices rise

- GBP weakness likely to extend

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The British Pound has resumed its trend of depreciation against the Australian Dollar and is quoted at 1.7755, which puts it near its lowest level in two years and those looking to sell Sterling and buy Aussie Dollars should be aware there is little to suggest the period of decline in GBP/AUD is over.

We had noted at the start of the week that the exchange rate was entering a period of consolidation that could have formed the basis of a recovery, however the view was purely technical in nature and we opined that the overarching trend of 2020 is one of weakness and there was yet to be a fundamental shift in favour of Sterling. The break below 1.7890 on Tuesday - which coincides with a surge in AUD strength right across the FX market - has opened the door to further downside with momentum indicators suggesting more follow-through declines are likely.

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Our initial assessment is that while there is an element of both Sterling weakness and Australian Dollar strength behind these latest moves lower in GBP/AUD, it appears that it is Australian Dollar strength that is the dominant force in the equation.

If we look at the headline Australian Dollar-U.S. Dollar exchange rate we note it to be a third of a percent higher at 0.7163 on Wednesday, but this follows on from a significant 1.64% surge on Tuesday, which makes for its strongest level since April 19.

The Aussie is in fact the best performing major currency of the day according to Pound Sterling Live's relative performance dashboard:

Key to the move higher in the Australian Dollar is the decline of the U.S. Dollar: the Dollar index, which is a measure of broad based USD strength has fallen sharply, largely courtesy of the rally in EUR/USD.

The most important point to consider when looking at U.S. Dollar weakness is its effect on commodity prices, which tend to increase when the Dollar falls. Global commodities are priced in U.S. Dollars, and a weaker Dollar naturally makes them cheaper thereby stimulating demand, and if we look at a list of commodities we can see that gold, silver, iron ore, and copper are all higher.

Australia is a leading commodity exporter, therefore the improved demand and prices boosts the country's terms of trade and ultimately provides the Aussie Dollar with a fundamental underpinning.

"The Bloomberg USD index plummeted, while precious metals rallied strongly – Silver particularly ripping higher, up ~15% this week, while Gold is now only 3% away from its all-time highs. The commodity currencies are back out-performing as a result – BRL, AUD, NOK, SEK and ZAR leading this week," says Robin Wilkin, Global Cross Asset Strategist at Lloyds Bank.

The Australian Dollar is therefore ultimately being driven by external factors and domestic concerns over covid-19 infection rates and potential Reserve Bank of Australia interest rate policy are all proving to be of secondary consideration for currency markets.

Should positive investor sentiment remain intact, and commodity prices continue to rise, we would expect Australian Dollar strength to push the GBP/AUD exchange rate yet lower.

The British Pound meanwhile finds itself one of the worst performing major currencies of 2020, beset by concerns over EU-UK Brexit trade deal negotiations which are unlikely to yield a result until at least October, creating levels of anxieties that will likely ensure the currency stays under pressure over coming weeks.

Another concern is the potential for further interest rate cuts and expanded quantitative easing at the Bank of England which would typically be expected to result in a weaker Pound.

"In contrast to Australia, the UK is at a higher risk of having negative interest rates which remain a downward risk to GBP," says Carol Kong, a foreign exchange strategist at Commonwealth Bank of Australia.

The second half of the week will see the Pound come into focus with the conclusion of the latest round of Brexit trade negotiation talks due on Thursday, where markets will be looking for signs of progress.

Negotiators remain deadlocked on issues concerning fishing rights, level playing field provisions and the jurisdiction of EU courts in the UK in overseeing the future trading relationship and with October being the EU's favoured deadline for the process, we don't expect any major breakthroughs this week.

"The probability of a no-deal Brexit has increased significantly. For this reason we are forecasting a weak pound in the short term and only a very moderate recovery later in the year. In fact, there is a high risk that the pound will suffer much more severe setbacks in the meantime than our forecasts suggest due to rising Brexit risks," says Thu Lan Nguyen, FX & EM Analyst at Commerzbank.

UK data will also be in focus with flash PMIs out on Friday, this should give an early steer as to how the economy performed in July and any signs of an accelerating recovery could be met with Sterling strength.

Also keep an eye on UK retail sales data for June as this will give an indication of how the all-important UK consumer is holding up. Markets are expecting retail sales to have grown 8% in June and a beat on expectations would be positive for Sterling. However, a weaker number would signal to markets that the Bank of England will need to boost its quantitative easing programme once more which is an expectation that is likely to weigh on the Pound.

Foreign exchange analysts at Nomura - the Japan-based multi-national investment bank - say they have downgraded their forecasts for the British Pound, listing a litany of problems facing the UK economy and its currency.

These include low real yields on government bonds, mobility data that suggests consumers are yet to emerge from their lockdown hibernation in a similar way to that of mainland Europe.

"The UK’s fiscal and monetary response is not matching that of its European peers, with the furlough scheme ending in October and the BoE’s QE pace now half what it was. The UK has second-wave risks that may appear by end-Q3/Q4, with an underlying higher case count and less adoption of mask wearing than its DM peers. The UK starts from a position of weak credit conditions, with IVAs on the rise (pre-COVID-19) and substantial double deficits too," says Jordan Rochester, an analyst at Nomura in London.

Nomura downgrade their GBP forecasts saying GBP/EUR should trade around 1.0870 into year-end, or lower.