Cable could snap back to reality

August 26, 2016

The recent improvement in UK data has seen many investors and analysts, ourselves included, ask a rhetorical question with a hint of sarcasm “Brexit, what Brexit?” Traders have apparently reduced their net short positions from record high levels as they realised the fallout in the immediate aftermath of Brexit was not as bad as many had feared. Granted, not all the economic pointers have been great but on the whole July has been a good month for the UK economy.

However, we don’t want to jump into any conclusions as the economy works at a much slower pace than the markets. The truth is, we don’t know what exactly will happen when Theresa May finally decides to trigger the Article 50 exit clause. We don’t know how long it will be until she finally does it. The long-term economic consequences could turn out to be a lot worse or indeed a lot better than what many expect at the moment. Given this uncertainty, the pound’s upside potential will most likely remain capped for the foreseeable future. In fact, the cable could potentially drop further lower before we see a bottom.

In the short-term, there is also a risk for sharp pullback in the GBP/USD. For one, speculators who bought the dip on the back of the improvement in UK data may begin to take profit. For another, the dollar shorts may also ease the pressure ahead of the Jackson Hole symposium, which begins tomorrow. While this much-talked about event could turn out to be a dump squib, some traders will be taking no chances.

So, there is the potential therefore for the GBP/USD to ease back in these last couple of days of the week at the very least.

Technical outlook:

The GBP/UUSD has been trending higher as macro pointers in the UK improved and the dollar took a back seat amid weakness in US data. If you recall, we highlighted the possibility for a short-term bullish breakout in one of our daily reports last Wednesday (see “Brexit, what Brexit? UK data continues to confound expectations” for more). Then, the Cable was trading around the 1.30 handle, a key short-term support which held as we had anticipated. This 1.30 level is also a key psychological level and I have repeatedly warned that the Cable could oscillate around it for a while post the Brexit vote, which is exactly what has been happening. Speaking of Brexit, the low that was hit on that Friday June 24 was at around 1.3225. As can be seen on the 4-hour chart, below, this level has acted like a pivot. Now that price has reached this level after an extensive rally, there is a risk for at least a short-term pullback. This view if supported further by the negatively diverging RSI, which indicates that the bullish momentum may be weakening. What’s more, there is a bearish trend line that has held as resistance around the 78.6% Fibonacci retracement level against the prior swing high, around 1.3265.

Indeed, the area above this 1.3265 level and below 1.3290 is a key short-term resistance zone. If the Cable were to eventually break through it then we could expect to see a more pronounced rally. In this potential scenario, the prior swing high at 1.3370/5 area would then become the first bullish objective, followed by 1.3510/35 area where the 127.2% Fibonacci extension level converges with a previous high. It is even possible for price to break through this area and fill the gap that had been left behind in the first weekend post Brexit, between 1.3535 and 1.3675.

But if the Cable snaps back as the abovementioned technical indications suggest, then we can forgot about those bullish levels for a while. In the bearish scenario, the first levels of support that need to break down are at 1.3200 and then 1.3160. The potential break below these levels are likely to triggered further momentum-based selling pressure, possibly until we get a much deeper retracement – for example a 61.8% or 78.6% pullback against the most recent swing low (not drawn on the chart). Some of the other potential support levels are shown in blue on the chart.

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