Last week, I made the argument that the GBP/USD would likely see more downside from here.
With the current UK government proposing an Internal Market Bill that overrides certain agreements agreed with the EU in the original withdrawal bill, the concern that the new bill would break international law led to a significant loss of confidence that a deal could ultimately be agreed. As a result, the GBP/USD showed an accelerated decline.
However, Boris Johnson has recently done a U-turn on a certain number of the proposed changes to the bill – in large part due to the fact that any arrangements that threaten the Good Friday Agreement would mean that a US-UK trade deal would be unfeasible.
In light of this, the GBP/USD has started to revive somewhat:
However, Brexit aside – COVID-19 cases in the United Kingdom appear to be making a sharp resurgence, as with other countries in Europe. With many cities now being put under local lockdowns – a national lockdown has not been ruled out. Moreover, one of the main reasons we saw growth in the GBP/USD over the summer is that growth in cases in the UK had largely plateaued in comparison to the United States.
Should a resurgence of the virus become severe enough that a national lockdown has to be reimposed, then the ramifications of this would stretch far beyond Brexit and it would not be surprising if the pound saw a very significant decline even if a deal was reached with the EU.
From a monetary policy perspective, the Bank of England has refused to rule out introduction of negative rates. Should COVID-19 cases continue to spike and the Brexit outcome is not optimal, then this course of action may ultimately be necessary to stimulate the economy once again.
The Bank of England is due to make its next decision on the policy rate on the 5th of November – the current rate stands at 0.1%. In the central bank’s August Monetary Policy Report, projections were made on the basis that COVID-19 would lessen in severity going forward and that the UK and EU would have a free trade agreement in place by the beginning of 2021.
However, with uncertainty having been reintroduced across both of these domains – negative rates may become particularly necessary as government support schemes start to fizzle out. Under this circumstance, negative rates may be deemed necessary to facilitate borrowing and ultimately keep consumer spending afloat.
Additionally, the central bank has no intention of raising the policy rate until “significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably”.
In particular, we see that inflation has in fact dropped further since March – currently at 0.2%. This marks the lowest level since 2016, and the Bank of England may well decide that lowering rates further is necessary to ultimately prevent a deflationary spiral – a situation where consumers believe that prices will be lower in the future – and are essentially willing to “sit out” Brexit and COVID-19 before making larger purchases.
Ultimately, whether or not a Brexit deal is reached – the British economy is not showing signs of being “in good nick” – to borrow a British phrase. October will be a key telling point for the GBP/USD. In the worst case scenario, a further spike in COVID-19 and an effective no-deal Brexit would mean that the Bank of England would be quite likely to lower rates further. Under such a scenario, I see significant downside for the pound – with conversely little long-term upside if these events do not materialise. From this standpoint, I do not see a favourable risk-reward for the GBP/USD at this time.
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.