Strategists at RBC Capital say this week will see the British Pound rise against the Euro - here is how they are planning to trade that view.

The risk premium attached to Sterling is set to diminish at a time when European political risk has emerged back on the radar, according to RBC Capital Markets.

The call comes as the Euro-to-Pound exchange rate is seen trading at 0.8862, which puts the Pound-to-Euro exchange rate at 1.1284, a five-day high.

Sterling had fallen to a one-month low against the Euro in the previous week, thanks to renewed concerns about political stability in the UK, but the Pound could benefit from an anticipated reversal of roles between the two currencies in the current week.

Markets awoke Sunday to reports that coalition talks in Germany had failed, while the UK government appeared to be showing unity over the question of how much the Brexit bill should be increased in order to push negotiations forward.

Risk-Off Environment Supports the Pound

“With the US Senate in recess for Thanksgiving and a generally very light data and event calendar this week, there is scope for the rise in FX volatility that has dominated the last two weeks to go into reverse,” says Adam Cole, chief currency strategist at RBC Capital Markets.

With US lawmakers set to break for Thanksgiving this Friday, President Donald Trump’s tax-reform bill is in suspense ahead of a Thursday vote in the Senate.

“EUR/GBP is a “risk-off” pair and would typically trade lower in an environment of improving risk appetite,” Cole adds.

Above: Euro-to-Pound at daily intervals. Captures summer strength and autumn weakness.

Senate lawmakers are expected to pass their own reform bill before meeting with House republicans to reconcile the two. That means meaningful news around US tax cuts is at least a week away for markets.

“The likely path of domestic risk premia also favours the downside, with a growing prospect of a broad-based agreement on a material increase in the UK’s offer to the EU on exit terms and hence a lurch forward in the prospect of moving on at the December EU council meeting,” says Cole.

Other analysts are expecting a good week for Sterling in anticipation of progress in the ongoing Brexit negotiations.

Prime Minister Theresa May is expected to double her earlier offer of £18 billion to the European Union as a “divorce settlement” in order to move talks along to the subjects of trade and transition.

An announcement is expected before the month is out and could help dispel fears, even if only temporarily, that a trade deal will not be reached between the UK and the EU before the UK departs the union in March 2019.

Meanwhile, European political risk appeared to come back to the fore Sunday when talks between German political parties, over the formation of a coalition government, fell apart due to “irreconcilable differences” over policies.

“Aside from a reopening of coalition talks (which seems unlikely) it is hard to see a constructive path forward in Germany and we continue to think political risk is underpriced in EUR,” says Cole

Above: Pound-to-Euro exchange rate at daily intervals. Captures summer weakness and autumn recovery.

The failure opens the door to the possibility of another election in the central European country, just two months after another vote returned a hung parliament. The only other option would be for Chancellor Merkel to seek the blessing of Germany’s president to attempt to form a minority government.

The Euro lost further ground towards the end of Monday, November 20 after German President Frank-Walter Steinmeier addressed media following an audience with Merkel in which he urged parties to work on forming a government as he characterised the situation as "an unprecedented situation in the history of the Federal Republic of Germany."

“With more geopolitical risk funnelling into EUR, the shift in longs towards GBP as a relative safe haven seems like the price action that’s going through the market,” says a daily briefing from the UBS Group AG spot foreign exchange desk, emailed to clients. “Until we get a clearer picture of the election risk, look to sell EUR/GBP.”

September’s election dealt a blow to Angela Merkel, whose party scored its lowest share of the national vote in more than half a century, leaving her weakened and in need of a broader coalition than in the previous period if she is to continue governing.

Quite apart from the policy uncertainty brought about by another election, markets might dislike the idea of a second German election given it would create scope for the anti-Euro and anti-establishment AfD to make further gains, after it rose to become Germany's third largest party in September's vote.

RBC Capital Markets recommends selling the EUR/GBP rate short at or around 0.8874, with a stop loss at 0.8970 and a price target at 0.8700, this gives a Pound-to-Euro exchange rate target just shy of 1.15.

The Euro-to-Pound rate was quoted at 0.8888 at the time of writing, down 0.33% for the session, which puts the Pound-to-Euro rate at 1.1248.

However, the strategy is not without risks as another analyst argues it will be hard to keep the Euro down for long.

"Selling the EUR on the back of the breakdown of German coalition talks last night may have seemed like a reasonable behaviour to Asian investors this morning. European traders, however, clearly have other ideas. The ability of the EUR to regroup and push higher over the past few hours is a very strong signal as to the resilience of the EUR currently," says Jane Foley, Senior FX Strategist with Rabobank.

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