With Brexit negotiations underway, the Pound to Euro exchange rate (GBP/EUR) is set to become increasingly prone to political headline risks and could fall.

Pound Sterling has shown resilience against the Euro and US Dollar of late having maintained a tight range against both currencies with traders adopting a wait-and-see mode to the now-underway Brexit negotiations.

The relatively benign performance by Sterling has strategists at UniCredit Bank a little frustrated as they say they were expecting a more pronounced decline in the UK currency and the resilience by the British Pound does put their negative view on Sterling view into question.

However, they are sticking to their guns and expect the Pound to decline.

“We believe that the market is currently underpricing political and economic risks and would advise positioning for GBP depreciation, especially against the Euro,” say UniCredit in a briefing dated June 19.

Subsequent price action following the release of the note suggests their analysis is spot-on.

Analysts argue that with the formal EU negotiations starting this week, and investors having already raised their hopes for a soft Brexit, the currency is more likely to find itself prone to negative headlines and downside risk.

In short, the prospect of disappointment is high.

“Our medium-term bearishness on GBP has been bolstered by the increased political uncertainty generated by the recent general election result,” says David Bloom, strategist at HSBC Bank Plc.

Foreign exchange markets witnessed a rally in Sterling back in April when PM May called a Generale Election - the thinking being that a strong Government could deliver a smooth Brexit.

The weakened state of the Government seriously undermines this assumption, and some argue financial markets are now being too generous towards Sterling.

The launch of the negotiations comes at a time when Theresa May is struggling to hang on to her job.

According to The Times the PM is at risk of rival leadership bids in the Conservative party.

Some MPs are ready to demand a no-confidence vote, the paper said. Chancellor Philip Hammond told the BBC that Britain will leave the single market, but should aim for a gentle departure.

In addition, there is still no power sharing deal with the DUP.

UniCredit think the recent developments in UK bond markets are rather difficult to square with political and economic dynamics at home.

Yields on bonds are a key driver of the Pound; when they head higher the Pound follows.

Nominal yields have held up well since the election.

“With the economy heading for a significant squeeze in real incomes, we think it will not be too long before UK real yields resume their descent, putting pressure on Sterling, especially against the Euro, which remains underpinned by both economic dynamics and political developments,” say UniCredit.

However, others in the analyst community argue that the Pound has taken as much political negativity as it can take and that there is a good chance it will appreciate.

“I feel on the political front a lot of negative to GBP is price by now and I see continued headline risk for calls for a soft Brexit which should help Sterling eventually grind back higher, my preference is to express this view through short EUR/GBP,” says a strategy note from UBS, released on June 19.

Analysts at Wells Fargo have meanwhile suggested that in their opinion, the election results are not likely to have meaningful effects on the British economy in the foreseeable future.

As a result economists at the bank are not inclined to make significant changes to their economic forecast at this time.

But any positive impacts of this will only be felt by Sterling longer-term:

“After political uncertainty in the United Kingdom starts to dissipate, there is the chance that Sterling depreciation could eventually be reversed.”

Broker Charles Stanley’s market technician Bill McNamara notes a level at 1.1300 which supported GBP/EUR’s recent rotation higher.

“It is worth noting that it (Sterling) rebounded off the lows last week relative to the euro, implying that there might now be some support at around 1.13. However, that price action is still somewhat inconclusive and the outlook remains unclear. Resistance is now at around 1.1460,” says McNamara.

Indeed, 1.1300 is a historic level which also supported the pair in the last – and corresponds with

EUR/GBP’s 0.89 at the top of its current range highs.

Euro Vulnerable to Technical Decline

The Euro meanwhile appears susceptible to losses as markets correct following a period of outperformance, which could help Sterling defend against significant downside, in the short-term at least.

According to Credit Agricole's FX positioning gauge, the EUR was sold for most of the last week.

"Regardless of last week’s development, speculative long positioning remains close to multi-year highs," says Manuel Oliveri, FX Strategist at Credit Agricole. "Given limited room of rising central bank rate expectations in the short-term, additional position squaring-related downside risk seems high."

To put this another way, the market is engaged in a one-way bet in favour of the Euro.

This makes for a market that is uneven and - importantly - prone to correction as traders exit those pro-Euro bets.

Broker Charles Stanley’s market technician Bill McNamara notes a level at 1.1300 which supported GBP/EUR’s recent rotation higher.

GBP to EUR chart

“It is worth noting that it (Sterling) rebounded off the lows last week relative to the euro, implying that there might now be some support at around 1.13. However, that price action is still somewhat inconclusive and the outlook remains unclear. Resistance is now at around 1.1460,” says McNamara.

Indeed, 1.1300 is a historic level which also supported the pair in the last – and corresponds with EUR/GBP’s 0.89 at the top of its current range highs.

A Taste of the Future?

A taster of Sterling weakness came as the Pound fell against the Euro, Dollar and other major currencies on Tuesday, June 20 following the release of a speech by Governor of the Bank of England Mark Carney.

The speech was actually the delayed release of the Governor's Mansion House address that was delayed in the wake of the Grenfell Tower tragedy.

Carney put paid to speculation that the Bank could consider an interest rate rise in coming months saying "now is not the time to raise rates."

Recall Sterling rallied after the Bank of England voted by a narrow 5-3 to keep rates unchanged at their June meeting.

Some members of the Bank's Monetary Policy Committee felt that elevated inflation was becoming too much of a risk and by voting to raise rates there was a view that the Bank was becoming impatient with this inflation.

They were also becoming impatient with the low valuation in Sterling which is seen as the key driver of this inflation. By helping the Pound recover they could help inflation head lower - thereby sticking to their mandate.

However, it appears Carney has short thrift for this speculation.

"From my perspective, given the mixed signals on consumer spending and business investment, and given the still subdued domestic inflationary pressures, in particular anemic wage growth, now is not yet the time to begin that adjustment,” says Carney.