European stock indices sold off in the first half of Friday’s session before staging a mild rebound off their lows as US investors entered the fray. The pound was also off its lows amid short covering, but it remains to be seen whether it will be able to reduce its losses further given the weekend risks for potential collapse in Brexit talks and therefore possible gaps in the FX and futures markets. As well as mild disappointment over what looked like a
half-hearted attempt by the ECB to shore up the Eurozone economy, badly hurt by the pandemic, and threats of further virus-linked damage – with Germany reporting the biggest rise in cases and deaths since the initial wave – it is the dreaded B-word that has once again come back to haunt investors this week. At the same time, some of the optimism over vaccines seems to have been priced in, although this still helped to lift Brent oil to above $50 per barrel.
Last important week of 2020 from a macro point of view
Heading into the week ahead, the immediate risk that investors are facing are the weekend talks between the UK and EU over a potential, but increasingly unlikely, Brexit deal. It is also probably the last important week for scheduled macro events. We have a handful of potentially market-moving data and four central bank meetings (see below). While data is important, the fact that investors are looking forward to 2021 with the rollout of vaccines, means they probably won’t pay too much attention to the economic calendar. Still, the central bank meetings could inspire pockets of volatility here and there. But as mentioned, Brexit talks are the immediate focus for Monday…
Fundamental differences remain in Brexit talks
After many deadlines, and countless hours of back and forth talks between the two sides, it now all hinges on Sunday, when the EU will decide whether they have the conditions for a deal or not. That’s what the European Commission President Ursula von der Leyen said this morning. Speaking at a Brussels summit of EU leaders, Ms von der Leyen said the UK and EU remain apart on fundamental issues: on so-called level playing field provisions and fisheries. She echoed sentiment from this side of the pond, with Prime Minister Boris Johnson saying there is a "strong possibility" of no deal.
With the Brexit transition period due to end on 31 December, Brexit talks are going to the wire and I wouldn’t be surprised if the deadline is pushed further out, as after all this is what has been happening repeatedly in recent years. Ultimately, a deal is in the favour of both sides and I still think that they will make a last-minute compromise. Still, whatever probability of a deal was at the back end of last week, this has now reduced sharply and is reflected by a weaker pound.
What does it all mean for the pound?
Well, right now the pound remains on the back-foot because of the uptick in no-deal outcome. And unless there is renewed hopes over a deal, the path of short-term least resistance remains to the downside.
But in so far as the slightly longer-term outlook is concerned, I think it literally is a binary outcome. If a deal is reached, hopefully this weekend, the pound could surge past the 1.35 handle it touched last week, before potentially heading towards 1.40. However, as the markets have – since March – been led to believe that a deal was going to be reached eventually, the greater risk is therefore if the UK departs without a deal. This outcome will probably come as a shock and could see sterling get a good pounding, sending the cable possibly down to $1.20. Here is how these potential scenarios will look like on the GBP/USD chart:
Source: ThinkMarkets and TradingView.com
There is a risk that sterling could gap higher or lower as talks could succeed or collapse. This uncertainty is reflected in the options market as well. For example, the cost of hedging swings in sterling over the coming week has reached near a seven-month high, according to Bloomberg.
US fiscal deal hits roadblock again
While there has been a breakthrough in EU stimulus stalemate, in the US talks between Democrats and Republicans have stalled again on the issues of business liability and state aid. There was optimism that a $900 billion deal could be agreed in the next week. However, according to a report in Bloomberg, Senate Majority Leader Mitch McConnell apparently wants lawmakers to proceed with a smaller bill that doesn't include state government aid and business liability protection. This is something that needs to be monitored closely in the week ahead as it could be among the factors causing a potential sell-off on Wall Street.
Central banks in focus