Cutting off your nose to spite your face – Brexit

Brexit Discussion and Analysis by Charles Porter:

 

Italian Prosecco, German automobiles and French wine. While bargaining chips are poured out only to be raked off the table, Brexit is coming more convoluted. No deal is better than a bad deal; no matter what you make of that statement, we’re all relatively unified behind the idea that a bad deal, or a no-deal, is inferior to a good deal. Surely the same should be true for the Eurozone, however, markets appear to be unsure about how to deal with this phenomenon.

 

Let’s not forget, after all, Brexit hurt the European Union and the Eurozone too. Undermining the longevity and confidence within the European project, the Brexit vote saw the Euro slide by 3.5% against the US Dollar.

 

Of course, the slide was far less magnificent than the decline of the British Pound. Losing nearly 12% of its purchasing power against the US Dollar, the Pound sank towards long-term lows across the board. The snap loss against the Euro was moderated by the implication of the Europe itself within the phenomenon of Brexit.

 

Despite popular misconception, Brexit is not idiosyncratic to the UK – far from it. The insulation of the trading value of the Pound Sterling-Euro cross was in the order of 30%. Whilst not directly attributable to the relative burden of a Brexit upon both parties, the inextricable relationship of mutual harm or mutual support should be inevitable.

 

In other words, it appears inconceivable that Brexit is a zero-sum game; surely, what one party ‘gains’ through progress and certainty is not a value taken directly from the other party. Admittedly if Brexit is, as I suggest, a positive-sum game then any advancement in negotiations can, and must, still have a larger effect within the UK than Europe. This is because there is more uncertainty priced into Sterling markets.

 

Turning to events following the referendum itself, we see that markets are not pricing Brexit negotiations as a positive-sum game. This is apparent because Brexit related movements within the Euro and Pound have been inverse, even when they ought to be mutual. Despite occasional ridicule of Mr. Johnson, prosecco, wine and cars are negotiating chips because mutual trade is unequivocally important to both sides of the Channel.

 

Progress in first round Brexit negotiations facilitates consideration of the second round concerning the future relationship of the UK and the EU. If the Florence speech was, as European officials have agreed, such a success then the Euro and the Pound ought to have both received a tailwind.

 

The Florence speech contained partial assurances and advancements on citizens’ rights, Northern Ireland, and a sheepish €20+bn guarantee.

 

It seems implausible that these guarantees do not considerably reduce the uncertainty within the Eurozone economy surrounding a no deal. The Prime Minister’s concessions to the European Union prevent funding and budgetary crises in the absence of Macron’s desire towards a budgetary union. Moreover, they weigh against the likelihood of public crises within the European Union that have marred it before (cf. migration crisis).

 

Therefore, the realisation of a bearish Euro and bullish Sterling following episodes of Brexit progress is remarkable. It is understandable that the Sterling-Euro currency pair would be bullish – in favour of the Pound. However, for the Euro to consistently weaken against, for example, the US Dollar and major international currencies, is astounding. Despite implausibility, this is what we saw following PM Theresa May’s Florence speech.

 

The same story is true following the recent and highly progressive EU Council meeting that concluded on 20th October. Donald Tusk, President of the European Council, announced that the Council has “agreed to start internal preparatory discussions” regarding the future relationship. Lending weight once again to the Florence speech, President Tusk praised the speech.

 

Once again, however, Brexit progress was met by considerable and sustained Sterling strength amidst Euro weakness. Cable, the US Dollar-Pound Sterling exchange rate, appreciated throughout the day and into the next week with the very same trends being reflected in the value of the Pound with respect to the Euro. In contrast, the Euro diverges strongly, trending downwards admittedly in a sign of Dollar strength, but also unmistakable Euro weakness.

 

So why?

 

Is the market incorrectly pricing the value of good Brexit news to the Euro? Or is the probability of an immense divorce bill, free trade and European cohesion so heavily priced into the exchange rate that Brexit progress simply doesn’t matter? Or, however unlikely, is no deal genuinely better than any deal for Europe?!

 

Well, it’s hard to say. Certainly, the latter two are not base cases for the Euro. Its strength has been derived from the re-emergence of economic growth and the hope of future inflation. What is certain, is that price action surrounding Brexit events should be watched closely.

 

Ultimately, the European Union is void of a legal binding. Whilst Article 50 seems vague and impenetrable, the clause does provide the Lisbon treaty with the capacity to secede from the Union. Therefore, in order to achieve  acceptable cohesion within Eurozone, which is the principal source of value for the Euro, the benefits of membership must continually remain in excess of its costs.

 

The quantification of costs and benefits within a diverse Union is not simple. However, it certainly spreads across more than pecuniary budgetary contributions and receipts.  With external trade deals proving popular within the Union (c.f. Canada), the future EU-British trading relationship will be important to the trade-off. Therefore, markets should price Brexit progress as mutually positive for the Pound and the Euro.

 

Find more Brexit analysis here.

 

Germany and the Eurozone

Discussion and Analysis by Charles Porter:

 

Accounting for a little over one fifth of total the European Union’s GDP, the systemic significance of Germany to the single currency is hard to overstate. Of the series of hard economic data that affect currency markets strongly, the Consumer Price Index (CPI) measure of inflation is certainly towards the top of the list. Therefore, this afternoon’s inflation data registered strongly throughout the single currency. Whilst volatility is low and markets appear ambivalent to most events, the release registered shy of a 0.2% change in the value of the Euro.

 

The stability of the European system is certainly where the Euro derives considerable value. As such, when it is disrupted, there can be considerable shocks to the value of the single currency. However, just as an independent, floating, currency is affected by idiosyncratic national data, so too is the Euro. Albeit to a lesser extent and perhaps muted, any salient data at the national level should be perceptible at the Eurozone level.

 

Consumer Price Index (CPI) inflation data for October was recorded at 1.6%, inferior to the previous year-on-year recording of 1.8%. Of particular importance to the strength of the Euro, the fall of 0.2% was unanticipated, meaning that the majority of the fluctuation was not already priced the market. This fact invited a selling-off of Euros while the inflation rate, aggregate economy and probability of and interest rate hike were re-evaluated.

 

The inflation rate is of particular importance to the exchange rate because it is the target of monetary policy. This week’s theme is undoubtedly monetary policy and interest rates. With several of the world’s key central banks meeting this week to decide the path of monetary policy, global bond, currency and equity markets could truly be reshaped this week. Bucking the trend, the European Central Bank (ECB) has already met and, last week, decided to taper the asset purchase programme of quantitative easing by €30bn per month commencing in 2018 from its present volume of €60bn per month.

 

The ECB’s dovish decision, including the possibility for a re-scaling of the asset purchase program and the guaranteed sustainment of reinvestment for maturing assets, sent the Euro down against its counterparts including the Dollar and Pound Sterling. Today’s announcement within the Eurozone’s major economy, Germany, made the probability of further Dovish central bank policy higher, at least for the immediate future. The release similarly foreboded wider Eurozone CPI inflation statistics that are due to be released tomorrow.

 

With employment pushing up and the economy close to, if not at, the natural rate of unemployment, inflation is expected to push up. If it continues to be subdued, following the spate of structural reforms in response to the European sovereign debt crisis, uncertainty will build. If the economy does not begin to behave normally, including the re-normalisation of the Phillips Curve, then market confidence in future and predictable performance will result in gradual risk-off strategies as investors hedge against risk.

 

The rise in inflation would justify the turn towards monetary policy normalisation that central banks including the Fed, Bank of England and ECB all appear to be preferring or have already taken. The confidence effect of a monetary policy normalisation would end the stagnation of crisis-time regulation and finally signal the return of prosperity and investment. Whilst the data release still only directly concerns Germany, as a single currency-leading economy, investors do trust it as a market leading nation.

 

The pricing out of any confidence effect alongside the pricing out of some of the probability of a rate hike led to the aforementioned depreciation of the Euro. With Germany painting a bleak picture of the probability of monetary policy normalisation and economic adjustment, we look ahead to the Eurozone data-heavy day tomorrow. Today’s German CPI reading stands in contrast to this morning’s soft data and confidence release. The bias that currency markets place towards hard vs. soft data is useful to elucidating underlying market confidence and sentiment.

 

 

The graph above depicts the spike devaluation of the Euro within the Euro-Dollar exchange rate during the statistics release event. Amounting to just shy of 0.2%, the episode represents a repricing of Eurozone-wide inflation, due to be released tomorrow, and the associated rate hike probabilities.

Political Risk and EM

Discussion and Analysis by Grace Gliksten:

 

Due to the potentially high returns for investments, individuals are finding themselves veering away from investing in the traditional industrialised economies and towards emerging markets. Understanding emerging market currencies, which have a unique set of advantages and drawbacks for investors, is imperative to getting the most out of your investment. An emerging market is categorised as a developing country that is experiencing growth in economic and political terms, as well as developing new social structures, such as a middle class. The finance and banking sectors of emerging markets are newly forming and thus do not have the gravitas of the banking systems of developed markets. Although the large, potential returns can be appealing, there is also significant political risk to investing in these economies.

 

Political risk is one the bigger concerns of investors looking towards emerging market currencies. The political systems of many emerging markets are still in their infancy and are, therefore, naturally unstable. The introduction of traditional democracy to many of these countries has caused an inevitable disruption to political life.

 

In these new political structures, individuals sometimes matter more than an institution. For example, in the UK, where entrenched political institutions, such as the House of Commons or even the government, hold significant influence over the individual, keeping individual power in check through their innate authority and extensive regulation. In developing nations, concentration is often on the individual in command. This leads to instability within the political environment as these individuals cannot always be controlled by those around them, nor are they constrained by the regulation and influence of a more powerful institution. As there is no control over what the individual may do, nor are there any checks on their power, the individual may make volatile decisions. These can come in the form of new policy decisions, taxation and a propensity to be individually influenced by other people.

 

Emerging market currencies are made more unstable by the ease with which people can be displaced from their positions, which can entail the introduction of a new set of ideals. Institutions, regardless of who is in power, remain the rock in which all ideas remain, irrespective of which political party resides within them. When individuals hold power, a change to the political party or head of state can mean the introduction of a new set of ideologies and ideas, as well as a move away from those previously held. This can lead to a tumultuous political system because the political direction is changed regularly, leading to shallow short-term political gains.

 

Due to the infancy of many emerging market democracies, it is believed that there is less governmental integrity. Whether real, and justified, or artificial and perceived infantile democracies and, de facto, lead to uncertainty and insecurity within economic relationships. Although bribing an official in an emerging market is no different or easier than bribing an official in a developed economy, the clout and influence of an official in an emerging market is typically far greater than one in a developed economy.

 

This is not only down to the entrenched political institution’s authority over their members, ensuring they remain true to the values of the institution, but also down to ingrained regulations preventing it. In the UK, the Bribery Act 2010 makes it ‘illegal to offer, promise, give, request, agree, receive or accept bribes’ under threat of prison sentence and unlimited fines. Corruption creates an unstable environment because investors cannot be sure that contracts and concessions have been won on merit, thereby leading to fundamental distrust within the system.

 

The potentially high return of gaining exposure to emerging market currencies should not over shadow the potential and unique risks that accompany it. Understanding the political risk associated with emerging markets is vital when trying to maximise your exchanges.

US Economic Growth

Discussion and Analysis by Charles Porter:

 

This afternoon, at 13:30BST, the Bureau of Economic Analysis, a subset of the U.S Department of Commerce, released economic growth data. Estimating the Real Gross Domestic Product (GDP) for the third quarter of 2017, the data release attested to an annualised rate of growth of 3.0%. Beating consensus economic growth forecasts, real GDP growth fell only slightly behind the astounding Q2 economic growth. As economic growth accelerates at the fastest rate in years, there is likely to be further upside potential within Dollar currency crosses.

 

Following a Dovish European Central Bank (ECB) decision yesterday and Hawkish Federal Reserve Board Chair news yesterday, the month-to-date trends of Dollar Strength and Euro retraction have gripped markets. On a trade weighted basis, the US Dollar is continuing to develop its strength, gaining considerable value within Dollar-exposed currency pairs.

 

The US Dollar broke into the high 1.15s within the Euro-Dollar cross rate around the time of the US GDP data release. Yesterday, a highly dovish monetary policy decision from the ECB sent the Euro on a strong decline. However, further momentum is likely to have been found on the Dollar-side of the equation, aided considerably by this afternoon’s hard GDP data. The GDP statistics mature the image of a healthy US economy which, in conjunction with an unexpectedly hawkish Fed, paves the way for a strong Dollar.

 

The data release comes ahead of a scheduled meeting of the Free Open Market Committee, the body in charge of setting monetary policy within the Fed. Hard data, particularly if it is of the stature of economic growth statistics, can have a positive effect upon the value of a currency. Strong GDP growth stands as testimony to the health of the economy and is indicative of the return upon investment that the economy is capable of producing.

 

Therefore, foreign direct investment, to name but one channel of cross-border flows of capital, is likely to tick up. Particularly if the macroscopic backdrop testifies that exportation-led growth has occurred, appreciative FX market movements are likely to prevail. By improving the base-case, underlying, performance that investors apply to economies, the domestic currency receives a tailwind. The currency market reaction in response to GDP data was likely to have been subdued by the complete discounting of a Fed rate hike at its meeting on Wednesday.

 

Ensuring that interest rates are not set too high so as to preclude strong and sustainable economic growth is a by-product of the price-level-based monetary policy target. Sustainable inflation, internalised at around 2% by most central banks is justified in virtue of its ability to lubricate the economy and facilitate growth. In turn, higher rates of growth as seen as highly likely to spill over into price inflation thereby increasing the pressure upon the economy to raise the rate of interest. The rate of interest explicitly rewards investors for saving money, providing an even more concrete support to the exchange rate.

 

The significance of 3% annualised quarterly growth should not be understated. The figure is undoubtedly a psychological threshold as well as impressive, in absolute terms, for a highly developed market economy. This growth level was down minutely from 3.1% in Q3. Moreover, it is the first time that economic growth has surpassed the 3% level for two consecutive quarters since the middle of 2014. The resurgence of economic growth could attest to a capitalisation upon the infamous global recovery and the health of the US economy.

 

Monday (30th October) will uncover further pieces of the economic puzzle when price level data and spending data is released. This date will also include the Fed’s preferred measure of inflation, providing important qualifications to the anticipated December rate hike.

 

The Week Ahead:

Discussion and Analysis by Charles Porter:

 

Bank of England: Stop and Think – Please!

 

This week was dominated by one event and so too will next week. Whilst monetary policy continues to, by and large, rule exchange rates, the Bank of England monetary policy decision on Thursday  must be watched closely. Despite a threat to central bank confidence from the inventor of forward guidance at the Bank of Canada, perhaps Dr. Carney should go back on his word and not raise rates.

 

Inflation within the United Kingdom is uncontrolled and rampant, surely, we have to raise interest rates! At least that’s what the first page of an economics textbook might suggest. In reality, a decision to tighten UK monetary policy on November 2nd could be extremely harmful to both the real economy and the Brexit negotiation period. The jibe above is not to suggest that Dr. Mark Carney is not a learned and intelligent man; by contrast, his successes at the Bank and, for that matter, throughout his career, have been commendable. Suggesting an imminent interest rate hike, however, seems foolish.

 

The Bank of England is not an extraordinary central bank. It too shares a mandate to control price inflation in the economy. Of course, as the economy overheats and inflation ensues, an increase in the rate of interest encourages saving over consumption, thereby cooling down the inflated economy. With year-on-year CPI inflation registering at 3.0%, according to ONS data released on Monday, the UK is unequivocally a price-inflated economy.

 

However, there is no domestic inflationary pressure. The rise in the overall price level is almost exclusively driven by an exogenous factor: the exchange rate. The Brexit result from the June 23rd referendum has seen sterling lose approximately 15% of its value, event to date, against the Euro. This has caused a delayed effect of import price inflation, and, therefore, general price inflation that grips the economy whilst reserves and stock are depleted and refreshed at inflated rates.

 

Therefore, domestic inflationary pressure may no longer be measured by the overall level of price inflation within the UK economy. Instead, by turning to the components of the CPI basket, degrees of exchange rate sensitivity can be isolated to understanding the UK economy. Presented below is overall inflation against food inflation and services inflation. Food inflation, is a basket component that is highly dependent upon importation and, therefore, the deterioration of Sterling’s value. Services trade, by contrast, is less determined by the rate of exchange and the market comprises of a higher propensity for domestic consumption and production.

 

 

If there were no domestic inflationary pressure outside of exogenous exchange rate price inflation then total inflation should be explicable by, for example, food inflation alone without a significant correlation to services inflation. Indicatively, above, we can see that this hypothesis is verified. The differential within food CPI inflation, measured by the right-hand axis, is far more significant than steady services inflation. Moreover, the adjusted scale seems to represent a good co-movement of food inflation with overall inflation.

 

 

To analyse the relationship between the two components of inflation, the dual graph below models the effect of food and services inflation respectively against overall price inflation. These graphs show that the source of inflation is most likely to be food, and thus import-led, inflation instead of an overheating domestic economy.

 

 

 

 

For the real economy over the medium-long term, this means that above target inflation is likely to be a fleeting phenomenon. This is a fact that Dr. Carney himself has recognised, but apparently suppressed over his recent appearances. The more concerning spill-over of this reality is that an increase in interest rates will not improve the state of the economy, potentially inviting disinflationary pressures into the future and stunting economic growth. There was a reason that the markets had ‘underpriced’ the probability of an imminent rate hike; markets simply didn’t believe it was a credible or sensible policy option.

 

If the Bank of England chooses to raise interest rates during either of its November (2nd) or December (14th) Committee announcement dates, then money will still flow to the Pound, raising its value. But only in the short run. The positive effect upon the value of the Pound will be determined by other announcements and monetary policy progressions of, particularly, the FED and ECB.

 

The race to raise rates between the ECB and the BoE boils down to a first mover signalling advantage. The first hike will, artificially or credibly, signal to the international market that the domestic economy is healing and ready to accommodate a higher cost of borrowing and reward upon investment. However, the long-term effect upon the Pound Sterling could reveal that an imminent Bank Rate hike is a mistake, with no further hikes even throughout 2018 whilst economic growth and inflation struggle to prevail.

 

Ultimately, speaking as an individual citizen, short term Pound strength is far less valuable to me, than a more stable and long run recovery. Whilst forward guidance central banking may take a hit, the pragmatic policy decision at this time is a no-hike and to allow Brexit progress, genuine domestic inflation, and economic growth to manifest. Call me a Dove, but I hope markets can call Mark Carney one next month.

 

 

Australian inflation data

Discussion and Analysis by Charles Porter:

 

There were high hopes for Australian Consumer Price Index inflation statistics released in the early hours of yesterday morning. The data released bucked the trend emanating from Australia this month. Showing under-expectation inflation, year-on-year inflation within the Australian economy fell short of the previous release. With monetary policy steadfast at record lows, stagnating inflation, the primary mandate and target of the Reserve Bank of Australia, pushes a potential rate hike even further away.

 

The Consumer Price Index (CPI) inflation report showed that the year on year change in the price level was 1.8%. This is below the target rate of inflation of 2% that the Reserve Bank of Australia is bound to. The Australian Bank chooses to target analytical permutations of the raw basket-of-goods data that the CPI represents. Under the title of ‘trimmed mean’ and ‘weighted median’ these two decision-leading variables were comparably underwhelming. The announcement hurt the value of the Aussie Dollar across the board, losing an indicative 0.5% against the US Dollar.

 

As with most worldwide data releases that we have seen in recent months, the reason for the shock devaluation of the Aussie Dollar is intrinsically linked to monetary policies. The inflation rate, being the target indicators upon which the mandate of the Reserve Bank is constructed, has an elevated impact upon exchange rates. The relationship exists because an increase in the inflation rate implies that a future or imminent increase in the target rate of interest issued by the central bank is more likely. The inverse is also true.

 

The interest rate, in turn, has two sides to the same coin. On the one hand, it dictates the cost of borrowing – how easy it is for economic agents to get hold of credit. On the other, it represents the reward for saving and, in turn, the reward for investment. Increasing the interest paid upon deposits creates an incentive for capital to flow towards the hiking economy. The increase in the money demand, given a stable and likely constrained money supply with a higher opportunity cost for borrowing, means that the new price level clears the market at a higher level. In short, the price and value of the economy goes up with higher rates of interest.

 

As mentioned above, the inflation rate was not only expected to hold at the previous rate of change, it was also expected to pick up. Inverting dominant market expectations, the actual data release fell short of previous results by 0.1%, falling even shorter of economists’ consensus forecasts. The exchange rate change represents a pricing out of some of the probability of an Australian rate hike.

 

The probability and upside potential to the Aussie Dollar from an interest rate hike may well have been overpriced. Despite an underlyingly Dovish central bank, month-to-date hard and soft data releases have been strong and signalled an Australian accession to the strengthening global recovery. The confidence value to a trend-breaking interest rate hike is almost of comparable value to the return upon saving and investment itself.

 

At face value, considered outside of its monetary policy setting, the rate of inflation only represents the erosion of value of one unit of domestic currency with respect to a basket of consumer goods over a given period of time. Therefore, above expectation or excessive inflation would be supposed to deteriorate a currency. The fact that we see the opposite should affirm in any observer the importance of monetary policy to exchange rates.

 

Heightened interest in an Australian interest rate hike in the past few months has been stifled by monetary policy decisions and press conferences signalling the Reserve’s dissuasion from a rate hike. With the release of CPI inflation, hard data has now taken the side of Dovish monetary policy. Future developments within hard data will be watched with extreme interest whilst the Reserve is certain to abide to a no-hike decision for now.

 

 

SGM-FX View of london

Strong UK economic growth

Discussion and Analysis by Charles Porter:

 

A short while ago, the Office of National Statistics (ONS) for the United Kingdom released economic growth data in the form of Gross Domestic Product (GDP). Measuring the total value of goods and services within the economy over a given time period, GDP is the favoured statistic to gage the actual performance and output of an economy. The data released this morning showed above expectation growth in excess of 2017 quarter two economic growth. The concomitant appreciation of the Pound Sterling was significant and sustained.

 

 

 

The data released by the ONS earlier this morning attested to a quarter-on-quarter (Q3 vs Q2) economic growth rate of 0.4%. This represents an acceleration of the economic growth rate as measured by GDP from quarter two’s 0.3% growth. This may seem insignificant, however, given the volume of quarterly gross domestic product, the absolute change in output is non-trivial.

The currency market appreciations were even more magnificent. Stealing rose immediately by almost 0.3% against the Euro and continued to rally throughout the morning and the afternoon. Against the US Dollar, the Pound rose by an almost identical magnitude, again, just shy 0.3%. The episode of Sterling strength was exaggerated by a familiar theme: prospective monetary policy.

 

On 2nd November 2017, just over one week from now, the Bank of England will announce a renewed monetary policy decision alongside an inflation report. Whilst a monetary policy decision always comprises of the propensity to move the market significantly, given the potency of monetary policy within developed financial markets, the significance of the November Bank event is particularly heightened. This is entirely thanks to comments from Mark Carney at a press conference explicitly suggesting that markets have considerably under-priced the probability of an imminent, before-year-end rate, rate hike.

 

The importance of legitimacy and confidence to a central bank, which, after all, is its single most valuable tool, means that financial markets will find a central bank in such standing as the Bank of England to be credible in their suggestion. Moreover, markets will realise that the Bank and its Governor would never risk sacrificing its reputation over erroneous suggestions (no matter how much Dr. Carney may appear if you Google image search unreliable boyfriend!).

 

Therefore, the Bank has almost completely committed itself, outside of all reasonable and unforeseen excuses, to a November rate hike. Otherwise, it faces the peril of losing the confidence of the policy and economy over which it governs. The release of ‘hard’ GDP data, the last of its kind before the potential November interest rate hike, was therefore the final of these scapegoats upon which to blame a decision reversal by the Bank’s Monetary Policy Committee.

 

The reason that markets have reluctantly, although ultimately positively, internalised and priced in most of the effect of an interest rate hike is because the economy doesn’t seem entirely fit to handle an increase in the cost of borrowing and the reward for saving and investment; the mechanisms behind a rate hike. This is because whilst inflation has picked up, wages are still stagnating amongst domestic service inflation. In fact, it appears that the exchange rate effect following the decisive Brexit referendum is solely to blame for far-above-target price inflation.

 

The exaggerated currency market fluctuation in response to the economic growth data was a confidence effect; the pricing out of uncertainty surrounding the potential rate rise. Ultimately, the fruition of an interest rate hike is far from certain. In addition to the instability and opacity of inflation within the United Kingdom, the composition of the Monetary Policy Committee itself may forbid the Bank from raising rates soon.

 

The overwhelming composition of ‘Doves’, those seeking to retain more accommodative monetary policy and who are likely to fall behind the curve, might mean that the Hawkish members, those favouring higher rates, are outweighed. The newer members of the Committee, whose preferences were previously unclear, have subsequently revealed themselves as more Dovish by ideology.

 

There will be considerable upside potential and downside risk within Pound Sterling currency crosses in the medium term. Volatility may well be seen to pick up whilst the European Central Bank (ECB) and Federal Reserve Bank conduct and conclude monetary policy meetings of their own. Of these two meetings, markets will certainly be looking most closely at the ECB meeting tomorrow. This is due to a similar foreboding by ECB officials of an imminent tapering of the monetary policy stimulus program of quantitative easing.

 

 

Eurozone Data and the Euro

Discussion and Analysis by Charles Porter:

 

 

Data coming out of the Eurozone has been positive and, more often than not, beaten market expectations both when concerning ‘hard’ data from the underlying economy of ‘soft’ data related to sentiment and confidence levels. The Euro, however, has been largely ambivalent throughout these releases. Whilst tax reform, Federal Reserve chairs and monetary policy dominates the US scene, there is one overwhelming Europe-wide factor influencing the Euro: Tomorrow. Tomorrow, the ECB will meet and will likely unveil its grand plan for the future of quantitative easing. Whilst Catalonia and Brexit have put blips on the radar, ECB expectations are what currently drive the Euro.

 

 

Two examples:

 

 

The release of what are normally two salient data announcements, the Euro-zone Consumer Confidence Index and Markit’s Purchasing Managers Index (PMI), fell almost flat on their face. Released yesterday at 15:00 and today at 09:00 BST respectively, both indices attested to a healthier Eurozone economy. The confidence index still presented low Eurozone consumer confidence in absolute terms. However, the figure not only attests to moderately higher confidence than before, but also showed an above-expectation increase in sentiment.

 

Similarly, today’s release of Markit’s Purchasing Manager’s Index (PMI) showed an 80-month high for the index. This was moderated by a slight down-turn and under-expectation performance of the sentiment underlying services and ultimately the composite index. Therefore, conflated interpretations in response to today’s release could be understandably attributed to opaque data. Ultimately, however, the strong and more considerable pick up in manufacturing PMI could have been supposed to at least result in a moderate strengthening of the Euro.

 

The graph below demonstrates the movement within the Euro-Dollar currency cross during these two releases. Within the two respective graphs, the data release point is demarcated by an orange market. Whilst a moderate spike is perceptible during this morning’s PMI announcement, the magnitude of Euro strength is less than 0.03%. Moreover, even if a strengthening of the Euro could be attributed to the soft data release, the upward revision was eroded throughout the day.

 

 

 

 

The reason for a lack of, certainly soft-, data sensitivity boils down to the anticipation of the ECB’s monetary policy decision tomorrow. Last month, the ECB’s Governing Council chose to hold its accommodative monetary policy unchanged. In a press conference following the press release, Draghi heavily signalled that the Governing Council is likely to have a plan ready for the tapering and eventual removal of quantitative easing by the October meeting. On Thursday 26th October, markets therefore expect major long-term news concerning the likely path of extraordinary monetary policy.

 

The asset purchase programme of quantitative easing is currently to the tune of €60 billion in addition to the reinvestment of maturing securities that have been purchased previously in the program. Speculation is dominating the Euro, and many European markets in general, with the speed and duration of stimulus tapering very much up in the air. Reassuringly, the scarcity of Eurozone government bonds means that the current pace of debt purchasing is unsustainable. Therefore, news really should be imminent.

 

The figure that has abounded on news forums, market analyses and interviews is a tapering of 50%, down to €30 billion per month. The level of reinvestment or pace or retraction should also be addressed. Presumably, the tapering will be gradualised to minimise the final cut off of central bank purchasing. Therefore, we look to see how the months-long path to removing quantitative easing stimulus will look.

 

Any hawkish and larger removal of monetary policy stimulus, i.e. a bigger reduction than 50% of the present net purchasing, will result in greater gains for the Euro. With the balance sheet inflating at the ECB, tomorrow’s decision will be watched with great interest by those exposed to foreign exchange and bond markets. Failing to meet the consensus threshold of quantitative easing tapering will result in losses for the Euro. Monetary stimulus requires an expansion of the money supply and its removal restores a tighter money supply that, with constant demand, raises the price and value of the currency. Significant upside potential and downside risk are present in the Euro.

 

 

No Hike Rate Hike… Please!

Discussion and Analysis by Charles Porter:

 

BoE: Stop and Think – Please!

 

Part Two: To raise rates or not to raise rates:

 

 

To analyse the relationship between the two components of inflation, the dual graph below models the effect of food and services inflation respectively against overall price inflation. These graphs show that the source of inflation is most likely to be food (above), and thus import-led, inflation instead of an overheating domestic economy.

 

 

 

For the real economy over the medium-long term, this means that above target inflation is likely to be a fleeting phenomenon. This is a fact that Dr. Carney himself has recognised, but apparently supressed over his recent appearances. The more concerning spill-over of this reality is that an increase in interest rates will not improve the state of the economy, potentially inviting disinflationary pressures into the future and stunting economic growth. There was a reason that the markets had ‘underpriced’ the probability of an imminent rate hike; markets simply didn’t believe it was a credible or sensible policy option.

 

If the Bank of England chooses to raise interest rates during either of its November (2nd) or December (14th) Committee announcement dates, then money will still flow to the Pound, raising its value. But only in the short run. The positive effect upon the value of the Pound will be determined by other announcements and monetary policy progressions of, particularly, the FED and ECB.

 

The race to raise rates between the ECB and the BoE boils down to a first mover signalling advantage. The first hike will, artificially or credibly, signal to the international market that the domestic economy is healing and ready to accommodate a higher cost of borrowing and reward upon investment. However, the long-term effect upon the Pound Sterling could reveal that an imminent Bank Rate hike is a mistake, with no further hikes even throughout 2018 whilst economic growth and inflation struggle to prevail.

 

Ultimately, speaking as an individual citizen, short term Pound strength is far less valuable to me, than a more stable and long run recovery. Whilst forward guidance central banking may take a hit, the pragmatic policy decision at this time is a no-hike and to allow Brexit progress, genuine domestic inflation, and economic growth to manifest. Call me a Dove, but I hope markets can call Mark Carney one next month.

 

 

Inflationary Pressures

Discussion and Analysis by Charles Porter:

 

Bank of England: Stop and Think – Please!

 

Inflation within the United Kingdom is uncontrolled and rampant, surely, we have to raise interest rates! At least that’s what the first page of an economics textbook might suggest. In reality, a decision to tighten UK monetary policy on November 2nd could be extremely harmful to both the real economy and the Brexit negotiation period. The jibe above is not to suggest that Dr. Mark Carney is not a learned and intelligent man; by contrast, his successes at the Bank and, for that matter, throughout his career, have been commendable. Suggesting an imminent interest rate hike, however, seems foolish.

 

The Bank of England is not an extraordinary central bank. It too shares a mandate to control price inflation in the economy. Of course, as the economy overheats and inflation ensues, an increase in the rate of interest encourages saving over consumption, thereby cooling down the inflated economy. With year-on-year CPI inflation registering at 3.0%, according to ONS data released on Monday, the UK is unequivocally a price-inflated economy.

 

However, there is no domestic inflationary pressure. The rise in the overall price level is almost exclusively driven by an exogenous factor: the exchange rate. The Brexit result from the June 23rd referendum has seen sterling lose approximately 15% of its value, event to date, against the Euro. This has caused a delayed effect of import price inflation, and, therefore, general price inflation that grips the economy whilst reserves and stock are depleted and refreshed at inflated rates.

 

Therefore, domestic inflationary pressure may no longer be measured by the overall level of price inflation within the UK economy. Instead, by turning to the components of the CPI basket, degrees of exchange rate sensitivity can be isolated to understanding the UK economy. Presented below is overall inflation against food inflation and services inflation. Food inflation, is a basket component that is highly dependent upon importation and, therefore, the deterioration of Sterling’s value. Services trade, by contrast, is less determined by the rate of exchange and the market comprises of a higher propensity for domestic consumption and production.

 

 

If there were no domestic inflationary pressure outside of exogenous exchange rate price inflation then total inflation should be explicable by, for example, food inflation alone without a significant correlation to services inflation. Indicatively, above, we can see that this hypothesis is verified. The differential within food CPI inflation, measured by the right-hand axis, is far more significant than steady services inflation. Moreover, the adjusted scale seems to represent a good co-movement of food inflation with overall inflation.

 

In this second part of this article, we analyse the underlying relationship between the components of inflation and analyse Bank of England monetary policy in light of these result. The conclusion reveals that a Bank of England rate hike next week could be foolish.