Japanese Election: Stocks up, Yen down

Discussion and Analysis by Charles Porter:

 

The triumph of the Liberal Democratic Party (LDP) and Japanese Prime Minister, Shinzo Abe, over the weekend has driven the Japanese stock market skyward and the exchange rate downward. Whilst the certainty of a freshly mandated national government usually affords a domestic currency with value, the specific brand of PM Abe’s premiership explains the Yen’s downturn. Following our analysis preceding this weekend’s Japanese election on a Liberal Democratic win, we revisit the election result.

 

Yesterday, the Japanese public headed to polling stations across the nation to elect its 48th House of Representatives. The snap election, the fourth that Abe has successfully contested, provided a mandate for the incumbent coalition between the LDP and the Komeito party to resume governing through its super majority. Achieving more than 310 seats within the 465 seat House, the coalition has the potential to, and will, control over two-thirds of the house. The democratic result seals the deal for Shinzo Abe to aggressively pursue his preferred policy path.

 

The abnormal circumstances surrounding the election, notably its surprise timing and the idiosyncratic decisions made by its candidates, has been joined by further abnormal effects within equity and foreign exchange markets. The consolidation of a likely result usually rewards the domestic currency with greater value and, dependent upon the preferred policy stance of the successful candidate, allows concomitant gains for the associated equity market. However, this has certainly not happened. The Japanese stock market has rallied, with the Japanese Yen steadily losing value up to and following Abe’s success.

 

For a candidate that is putting the economy, and secondly the consolidation of national democracy, at the forefront of his now certain premiership, a devaluation of the national currency following an above-expectation result is certainly extraordinary. The reason concerns Abe’s addressal of the systemic Japanese macroeconomic problem.

 

The problem, as Princeton and Nobel Prize-winning economist and Japan specialist, Paul Krugman, points out is the deflationary pressure and low growth that the Japanese economy has endured for decades. Periods of severe deflation, an extremely concerning and eschewed macroeconomic reality, have gripped the Japanese political economy sporadically throughout the period. The solution that Krugman points to is an increase in the money supply and general stimulus; big time.

 

The Bank of Japan has this capacity. Either through the rapid acquisition of vast amounts of governmental or private debt, the Bank can increase the money supply, thereby increasing the lending facility of private banks, financing government expenditure, and generally increasing the availability of credit and the circulation of money.

 

This brand of macroeconomic and political guidance is exactly that endorsed by the successful candidate, Shinzo Abe and the Liberal Democratic Party. Whilst this may ultimately be what Japan needs in the long-run to finally escape its deflationary and recessionary pendulum, it is nevertheless damaging to foreign exchange markets.

 

Ultimately, the self-branded policy set, “Abenomics” that Mr Abe has begun throughout his previous term amounts to ultra-accommodative monetary policy and fiscal stimulus. Whilst seeking popularity with a trifecta including structural reform and wage growth, the heart of Abenomics is bipartite and consists of monetary easing and government spending.

 

As many of my articles have explained, loose monetary policy leads to a depreciation of the exchange rate by increasing the supply of money and decreasing the reward for investment. The former lowers the effective price of the domestic currency whilst the latter decreases its attractiveness from outside and within; thereby leading investors and savers to look elsewhere for their currency exposure. Therefore, it is ultimately unsurprising that the confirmation of and lead up to Abe’s success was characterised by consistent gains on the Nikkei, the Japanese stock market, and consistent losses for the Yen.

 

A refreshed mandate for this band of Liberal Democratic rule may be positive for the long-run success of Japan; clearly the retention of a super majority goes some way to proving the popularity of Abe. Whilst such accommodative monetary policy may lead to an undervaluation of the Yen for a considerable time, the characterisation of the Yen as a safehaven currency, at least for now, will always leave it with interesting, if uncertain, value.

 

 

USDJPY – the appreciation of the Dollar against the Yen has been pronounced whilst the electoral certainty of another Abe win increased. The brand of Abenomics, relying first and foremost upon fiscal stimulus and expansionary monetary policy, has depreciated the Yen against its counterparts. 

 

Safe Haven Currencies

Safe Haven Currencies are an imperative, yet complicated, business. Rising in value and price in the face of Geopolitical and general uncertainty and risk, their trend often defies not only other asset trends but also logic. In this article, we analyse known havens and the possible causes for their existence. 

 

US Dollar

 

The US Dollar is not a safehaven. That may come as a surprise because one could make a strong argument for its stability as the most liquid and heavily traded currency in the world. This characteristic, in fact, is confusingly why it is not a safehaven. The liquidity and stability of the US Dollar in good times is one of the reasons why it is the world’s major conduit for business. Companies and corporations over the world flock to the consistent purchasing power of the Dollar, supported by an immense population underneath it.

 

This corporate and financial exposure of the US Dollar is why it is not a safehaven. When times are bad, i.e. when global geopolitical risk is mounting and looking unsustainable, it is these institutions that investors and stakeholders wish to minimise their exposure to. Therefore, there is a de facto exodus from the dollar, flooding market supply which, when met by low demand, allows the price of the Dollar to fall.

 

Despite lacking the status of a safehaven, the US Dollar is unequivocally stable and, unsurprisingly, a popular currency amongst the expatriate community. With the Dollar consolidating considerable value over the past few weeks, many analysts see little reason for this trend to reverse into 2018.

 

 

Japanese Yen

 

The election is dominating the political economy of Japan at the moment. Before this weekend’s event, most immediate fluctuations in the value of the Japanese Yen are likely, although not certain, to be derived from the leadership contest. However, with crises of industry affecting wider Japanese markets, the supremacy of the election to the Yen cannot be guaranteed.

 

Critically, also, the Yen is a fully fledged safehaven currency. Therefore, whilst the domestic environment will be reflected in the value of the Yen, the global geopolitical atmosphere has the propensity to make the Japanese currency highly volatile. As a central safehaven asset, alongside the Swiss Franc and Gold, its price is proven to vary inversely with other non-safehaven currencies.

 

Therefore, whilst the value of the Yen may, at times, be uncertain, it can usually be considered overpriced in globally bad times and under- or fairly priced during good times. The rising tension within the Koran Peninsula creates an interesting new dynamic within Japan and the Yen. Whilst the value of the Yen should rise during times of geopolitical uncertainty and insecurity, its geographical proximity to the epicentre of the troubles makes its relevance as a safehaven against North Korea questionable.

 

 

Swiss Franc

 

For almost 100 years, the Swiss Franc has acted as a safehaven currency. A politically and socially stable country, Switzerland is also a quintessentially neutral player on the international stage. Known for its strong and entrenched financial system, confidential banking and low inflation rates, it is considered by many to be one of the most stable currencies in the world. Although these are some of the most likely reasons why the Swiss Franc is a safehaven currency, the nature of a safehaven currency means one cannot know for certain.

 

What we do know is that investors flock to the Swiss Franc when geopolitical or natural challenges arise. Bucking the trend, when all other currencies seem to be shedding value, the Swiss Franc appreciates. The Swiss Franc is essentially a disaster fund, so whilst you may not protect yourself against inflation and loss in good times, you can be confident that the Franc will stay strong.

 

 

US Inflation and Monetary Policy

Discussion and Analysis By Charles Porter:

Last week’s inflation data within the United States was strong, yet underwhelming. It has led to significant speculation on the US Dollar given the significance of the rate of inflation to currency markets. When the data was released, the US Dollar spooked significantly, losing 0.4% of its value against the Euro instantaneously, demonstrated in the graph below.

 

 

 

The international economic calendar has been littered with speeches and comments by central bank members over the past couple of weeks. The position of central banks that are of global systemic significance, the Bank of England, the US Federal Reserve and the European Central Bank, should therefore be clear. However, market confidence and consensus on any central bank’s preferred path of action is weak, at best.

 

The reason for this is a surplus of conditionality within central bank speeches: “it depends”; “we’ll see”; “if… then”. The most prevalent theme coming from governors and committee members alike is that future data will, almost exclusively, determine the path of monetary policy. Forward guidance, the method of choice for many central banks that seeks to inform and guide the market through monetary policy over the medium run, breaks down under such conditions.

 

Therefore, the sensitivity of currency markets, a market that is highly dependent upon monetary policy, is heightened during times of uncertain monetary governance, particularly around key data releases. The mandate of central banks primarily, although not always exclusively, revolves around the price level; the rate of inflation within an economy. Therefore, a direct reading or estimation of the price level will hold the most market moving potential with indicators that typically influence the domestic price level coming in at a close second.

 

Friday afternoon saw the release of the latest Consumer Price Index, the favoured instrument to measure the rate of inflation. The higher that inflation creeps over target, the more the pressure mounts upon a central bank to increase interest rates either reactively or preventatively. An interest rate hike in turn, by definition, promises investors a greater return upon their investment. As we anticipate a gradual and fragile emergence from abnormal, hyper-loose, global monetary conditions, then there will be an added currency benefit. The pecuniary benefit will unilaterally strengthen the domestic currency, in this case the US Dollar, because of a renewed confidence in the capacity of the economy.

 

Therefore, when the aforementioned data sensitivity produces an effect that makes an interest rate hike less likely, movements within currency markets manifest as greater downside than the underlying data may warrant. Below-consensus CPI inflation data is a case in point. The September year on year inflation data released last week still stood at above the median target of 2%. In fact, the Bureau of Labour Statistics reported that aggregate inflation stood at 2.2% percent, up a seasonally adjusted 0.5% in September alone.

 

Indicatively, without an analysis of the underlying dynamics of inflation, the headline figure of 2.2% is sufficiently high to facilitate an interest rate hike soon, in accordance with Yellen’s, and her Committee’s, suggestions. With the meeting of the Federal Open Market Committee, the US independent body responsible for setting monetary policy, fast approaching at the beginning of November, data releases between now and then will prove to be increasingly critical. Monetary stimulus tapering has already begun with the curtailment of quantitative easing stimulus this month. Another signal that the US is ready for a harder, interest rate led, monetary policy tightening will be highly fortuitous for the US Dollar.

 

 

Yellen’s hurdle

Discussion and Analysis by Charles Porter:

 

The Federal Reserve Board’s Chair, Janet Yellen, has serviced in her present office since 2014. Her four-year term ends in February 2018 and her reappointment looks uncertain at best. Regardless of whom the White House appoints as the next Fed Chair and Chairman of the Federal Open Market Committee, the body responsible for setting interest rates, a pivotal moment of Yellen’s appointment in office will fall upon her and the Committee that she is, at least for now, heading.

 

Dollar weakness was eroded gradually last week, carrying through the weekend, with mild corrections manifesting throughout the middle of this week. This was in considerable part down to the considerable action and apparent hawkish sentiment hidden within the US Fed’s seemingly dovish policy action. The dot plot, a measure published detailing the stance of each of the Federal Open Market Committee members about the future progression of US monetary policy, still suggests a before-year-end tightening of monetary stimulus and the fulfilment of foreboded quantitative easing stimulus.

 

Quantitative easing has been pursued within the US to try and stimulate the economy using the preferred instrument of monetary policy whilst interest rates have become useless; once they approach the zero-lower bound. However, quantitative easing has ballooned the balance sheet of the federal reserve board immensely, with an estimated 4.5 trillion dollars on account. The indebtedness of a central bank is not a problem, as it may be with a corporate or government institution. Unconstrained purchasing is, after all, the primary capacity of a central bank, differentiating it as a unique form of financial institution.

 

However, what is problematic is crowding out, whereby central bank purchases are precluding open market demand from realising their assets and artificially inflating the price, or lowering the yield unsustainably within bonds. This can lead to the view that the reduction of monetary policy stimulus is implausible and markets simply could not take over the burden that a central bank has taken upon itself. Therefore, markets can become jittery, especially if they feel the rate of tapering or the cessation of re-investment is excessive.

 

However, the ultimate tool that a central bank has is not really the interest rate or the capacity to purchase bonds. As our interview within Dr. Waltraud Schelkle of the London School of Economics further attested to, credibility is the real life-line of a central bank. Therefore, the expectations alluded to above must be fulfilled for markets to credibly internalise the forward guidance of a central bank and make their future actions credible.

 

Evidently, if hard data precludes the central bank from implementing a previously announced or foreboded policy action, i.e. if the action would be damaging to the present economy, then the bank will lose credibility from implementing a previous plan anyway. Central banking therefore frequently appears as a juggling act of expectations and pragmatism, as much as economics.

 

This afternoon, at 13:30BST, the Bureau of Labour Statistics will produce a Consumer Price Index report detailing the inflation characteristics within the US economy. Given that the mandate of a central bank is orientated around the inflation rate and price stability, this will be one of such hard data that will, to a significant extent, determine how the Fed’s juggling act plays out. The decision that Yellen’s Federal Open Market Committee takes will set a legacy for the next Chair and, for that matter, the members that join this individual according the present Committee vacancies.

 

Market sensitivity to the inflation rate publication will therefore be high. A higher than anticipated rate of inflation will lead to a strong appreciation of the US dollar. However, a failure of inflation to pick up, a trend that many economists and central bankers have warned about, will cause a shock depreciation while the potential reward of a future higher rate of interest is priced out of US Dollar currency pairs. Individuals exposed to or looking to gain exposure to the US Dollar will be well advised to pay close attention to this afternoon’s publication.

 

While the labour market report published at the end of last week is usually a good indicator of price level mechanisms, the distortions within that data due to the natural disasters that the US has recently suffered may weaken it as a predictor of the macroeconomy and inflation. The report showed payrolls worsening yet the rate of unemployment falling; an apparently contradictory result. Whilst market sensitivity might be diminished by expected inaccuracies and the attested ambivalence to present low inflation within the Committee, the aforementioned expectations still stand.

Japan’s critical election

Discussion and Analysis by Charles Porter:

 

Parliament is dissolved and the date is set for Japan’s election later this month. A bold political move by incumbent Japanese Prime Minister, Shinzo Abe, now looks likely to achieve its ultimate purpose. The significance of Japan’s election to the Yen cannot be understated. The importance spills over not just from politics, but also geopolitics, economics and the political economic architecture of Japan.

 

The date is set for 22nd October for Japan’s election. As the election result has become more certain in the polls, the upside potential to the election has been priced out of the market, leaving only downside risk of a surprise Abe defeat. This effect is not uncommon as the market reaches a consensus that the base case scenario for the election is a win for Abe’s Liberal Democratic Party. Therefore, this result becomes almost entirely priced in, leaving only dwindling uncertainty as the upside potential upon the election result.

 

So, why is Abe’s win so likely?

 

It’s probably not down to political pragmatism and the assumption that only an incumbent with a guaranteed win would call a snap election. Theresa May’s conservative government proved that well. In free and fair elections, the election result can almost never be certain and the underlying tensions within an electorate can be spun into either a weaker coalition government or oust the incumbent entirely.

 

It is, however, still likely that Abe foresaw a convincing likelihood of consolidating his position within the parliament of Japan’s bicameral political economy. What has more concretely led to the base case of Abe’s success is the apparent disarray of an opposition.

 

There was already wise money on Abe calling a snap election, however, just not so soon. This is because of the apparent present incapacity of the opposition party, the Democratic Party, to provide a viable voting alternative. Perhaps this is why they grabbed headlines early on announcing that they will not field a candidate for the election.

 

Instead, the main opposition party has enforced and teamed up with the Kibō no Tō, the Party of Hope. This party is certainly non-trivial. However, the success and recent popularity of Abe, who has been governing Japan for 5 years now, ought to be sufficient to counteract any swings in public favour towards the Hope Party. The Hope Party is certainly credible and admirable, founded by Tokyo’s first female Governor Yuriko Koike. However, with the tension continuing to mount and spill over from the Korean Peninsula, the proven and moderately successful state-level leadership of Abe is likely to triumph.

 

So why does the election matter?

 

The governing Japanese party arguably has more power over the Japanese economy than many advanced Western economies constitutionally allow. The (central) Bank of Japan’s independence is highly new and has, arguably, seen a moderate retrenchment following Abe’s election to the premiership.

 

Previously subsumed within a state department, the Ministry of Finance, the macroeconomy could be steered from a politically exposed office. Given the salience of the economy to Japan following enduring stagnant inflation, and at times deflation, the politicisation of central banking was not such a bad thing. Many would argue that because responsible and medicinal central banking was a salient voting issue within the Japanese electorate it generated a democratic and binding mandate to pursue economic growth with a lubricating inflation level.

 

Abe’s commitment to monetary stimulus, even within the now more independent central bank makes his election pivotal for markets, and particularly those exposed to foreign exchange. The confidence effect of what has been labelled ‘Abenomics’, his tripartite stimulus and (mild) structural reform program, is critical for Yen strength. With an unproven record of monetary policy, a high salience issue, on the part of the Party of Hope, both the market’s desire and the Japanese public’s support is likely to be consolidated within an Abe win.

 

There is a final and pervasive reason why those exposed to foreign exchange risk, perhaps not even to the Yen, should care about the Japanese election. The Yen is regarded as a safehaven currency, meaning that as uncertainty and risk enter the world environment, the value of the currency paradoxically rises. In effect, the value of safehaven currencies, and thus the Yen, should inversely correlate with the value of other developed currencies and assets.

 

A threat to the political composition and political economic exposure of a safehaven asset, and particularly a currency, can undermine its status. Therefore, a core trading relationship within the Yen could be threatened by political instability and upset caused by a non-base case electoral performance.

 

In summary, the intrinsic link between politics and economic governance, the status of the Yen as a safehaven currency, in addition to the normal tumult caused by an election, all make the Japanese snap election all the more important. A non-Abe, non-Liberal Democratic, result could at this point upset markets meanwhile another term of government is the market base case.

 

Data Light and Talk Heavy

Discussion and Analysis by Charles Porter:

 

Whilst the headline above may be many people’s aggregate impression of financial markets and politicians regardless of the short-term conditions, it is certainly the general impression of this week. With only minor data released within the UK on Tuesday and significant US data waiting until Friday, once again, the musings of Central Bankers in organised speeches will continue to be the main market-only news of this week.

 

The main driver of foreign exchange markets over the past weeks have been related to monetary policy. The hyper-low interest rates and stimulus programs that seem to be an ever-enduring paradigm of the macroeconomy at present may finally begin to be unwound. Interest rates within most developed economies have been threatening the zero lower-bound either since the financial crisis, or, in the case of the Eurozone, following the start of the European Sovereign Debt crisis.

 

In this low interest environment, an interest rate hike has a double and mutually enforcing effect. Firstly, the interest rate at face value raises the reward for saving and investment. Speculative investment and asset allocation will therefore favour an economy and interest rate that provides higher rewards. The associated currency will therefore receive a boost, derived from heightened international demand for the currency, that will spill over into value of the domestic currency.

 

However, the second, and arguably equally important, effect derives from bucking this enduring monetary policy and economic paradigm. Raising interest rates immediately signals the belief of a central bank, and therefore probably economists alike, that the economy can contain higher rates of interest. Therefore, it signals that domestic and international investment and public debt will be sustainable when the returns upon deposits and assets increase.

 

The latter belief will signal that the economy is returning to health and, following such prolonged periods of hyper-low interest, output and growth may prevail. This effect will clearly also lead to the purchase of the associated currency because it signals that economic performance may well rise in the near future. If a currency appreciation can be called an advantage, something that it is often not labelled as due to the negative effect upon domestic export markets, then there is certainly a first mover advantage. With hyper low interest rates pervading throughout almost all developed, credit- and investment-worthy nations, the first to reward significant rates of interest will receive considerable capital inflow given the rising opportunity cost associated with its counterparts.

 

With the absence of considerable data outside, perhaps, Tuesday’s UK trade balance data and Friday’s forthcoming US CPI inflation, the main highlights are likely to be found within further speeches made by central banks. Of particular importance within these speeches will be President Draghi’s remarks later this afternoon alongside other members of the European Central Bank. Whilst the White House considers the nomination of Federal Reserve Chair board, a lot of interest will continue to be paid to US monetary policy.

 

The widely priced in probability of a rate hike coming from the US before year end, QE tapering announcements within the Eurozone likely to be guided forward as of October to start in January 2018, and an uncertain yet likely Bank of England rate hike before year end, all mean that any signal or comment suggesting that a hike is less likely will create a greater distortion within money markets than a positive signal. Therefore, there is likely to be greater downside risk associated with each of these pivotal speeches than upside potential. Therefore, until the official respective meetings of the world’s key central banks and until the next Federal Reserve Chair is appointed, meetings are unlikely to produce domestic currency market appreciations.

Day of Reckoning – Catalonia Part 2

Discussion and Analysis by Charles Porter:

 

This afternoon, the culmination of the Catalonian independence vote may arrive. We analyse the implications within currency markets, predominantly the Euro. In doing so, we offer you an insight into the likely performance of the Euro when it is potentially confronted by a declaration for Catalonian secession later this afternoon.

 

Evidently, Spain has long given up the Peseta, therefore, the effect of the Catalonian referendum upon exchange rates will be localised within the Euro. Given that the single currency brings about de facto insurance to a national idiosyncratic risk (c.f. Mundell 1973), it is possible that the Euro will show relative ambivalence to any possible announcement at around 5pm BST today. The price behind the Euro is still derived primarily from the supply and demand for the currency, however, the understanding behind the value of a currency union must be based upon its cross-border nature. In effect, while the Catalonian referendum might credibly be of national significance, on the Eurozone grand stage, any national effect resembles only a regional shock.

 

The effect within Spanish bonds and equities has certainly been felt. Bonds, for example, are paying a higher yield, reflecting the risk and uncertainty that a Catalonian secession from Spain would create. However, overwhelmingly, these national indicators and markets have managed to remain calm and price the risk modestly. Equities of banks exposed to Spain and Catalonia have been more volatile. These banks have even felt it necessary to insure against a Catalonian secession by insuring their ability to physically relocate and, in the meantime, by adapting their legal headquarters.

 

Whilst our analysis of Carles Puigdemont highlighted his infatuation and belief in Catalonian independence, the constraints that the region’s President faces may precipitate a more moderated response during his speech this afternoon. If the actions taken by Puigdemont are moderate, meaning anything short of a declaration of independence, then I expect a comparable calm within international markets.

 

If Puigdemont pursues a democratic (or bureaucratic/diplomatic) and conversational approach then the risk that is priced into the market reflecting the uncertainty surrounding the Spanish and Catalonian economies will be partially priced out – allowing the Euro and affected Stocks and Bonds to appreciate. Open democracy, conversation and mutual agreement lead to more gradual, predictable, and stable processes, rewarding bonds, equities and assets tied to both economies with more value. Therefore, the effect upon Catalonian and Spanish equities and bonds will be stabilising; lowering the yield on bonds and raising the price of equities and assets.

 

However, in the more unlikely, yet plausible, scenario where Carles Puigdemont achieves and submits a signed declaration of independence then further risk will be priced into the market. Capital will leave the areas most affected by political risk, namely Catalonia and Spain, as uncertainty deteriorates the investment environment. However, given that neither Catalonia nor Spain operate using their own, unique, currency, it must be considered whether the common currency, the Euro, will feel the damage.

 

Whilst the spill over from Catalonia to Spain is inevitable given the analysis within the preceding article, the significance of Catalonia to the Euro is less certain. Accounting for a little over 2% of total Eurozone GDP, Catalonia is not critical to the output and performance of the Euro, but it is also not negligible. Moreover, the longer-lasting potential spill over effect upon both Spanish and Catalonian GDP, should Catalonia become independent and outside the EU, could be strongly negative, particularly if a tariff barrier to trade becomes effective.

 

The fiscal significance of the Eurozone and European Union is clearly low; the European Budget contributes for expenditure of around only 1% of Eurozone GDP. However, Spain’s net European Budgetary contribution to the EU budget will be distorted and the vacuum must be filled by international compensation, or left to fall. With the prospects for European integration increasing according to the foreign policy and integration stance of French President, Emanuel Macron, political risk and fiscal reshuffling could be damaging and disparaging.

 

Perhaps the most valuable present feature of the European Union is the world’s largest single market; free of barriers to entry and internal tariffs. The population of Catalonia as a percentage of the total population of the single market is around 1.5%. To some extent at least, the strength of the single market will be minorly diminished. However, the practical impact of a reduction in potential trading individuals will be negligible given the replenished prospect for further EU accession and an undervalued Euro, for example against the pound, spurring the competitiveness of the Eurozone.

 

The Euro has shown moderate sensitivity to the progression of the Spanish constitutional challenge posed by Catalonia. Regarding the future, highly moderate strength will be conferred upon the Euro if the diplomatic, gradualised, path is taken. Similarly, if unilateral independence is declared this afternoon, the Euro will suffer immediately, and into the trading day tomorrow.

 

 

Although moderately shrugged off by the Euro, the end of trading day spike showing Euro weakness is likely to signal a sell off of Euros before the weekend Catalonian referendum on October 1st. This afternoon’s announcement should prove to be more market sensitive, particularly if the status quo is broken and Puigdemont claims Catalonian independence.

Day of Reckoning – Catalonia Part 1

Discussion and Analysis by Charles Porter:

 

This afternoon, the culmination of the Catalonian independence vote may arrive. We analyse the implications within currency markets, predominantly the Euro. In doing so, we offer you an insight into the likely performance of the Euro when it is potentially confronted by a declaration for Catalonian secession later this afternoon.

 

While Carles Puigdemont, Catalan President, prepares to address the Catalonian parliament, the tension inside the Spanish political economy is mounting. Following the now 10-day-old referendum on Sunday 1st October, Puigdemont feels he is vested with a mandate to declare the secession of his municipality from Spain.

 

The uncertainty and conflict that surrounded the initial referendum should impact markets because it signals the propensity for riots and conflict to ensue in response to developments. When Puigdemont addresses parliament, there is an acute risk that the political composition of Spain, including Catalonia, is exposed. What’s more, underlying tensions that are exposed will likely realise their propensity to generate further conflict. Amidst the uncertainty surrounding the extent of devolved powers, particularly policing, pragmatic and responsible public actions cannot be taken for granted.

 

The Spanish Prime Minister, Mariano Rajoy, has vociferously displayed his unwillingness for Catalonia to leave Spain. Members of the incumbent Spanish ruling party have displayed uncompromising stances towards the Catalonian establishment and public displaying empathy or active support for secession. For example, threats to arrest political public office holders seem credible and are generating concern. It is therefore plausible that convoluted instructions will cause irresponsible public law enforcement, thereby escalating the tension between the nation and the region.

 

So Why is Spain such a Big Deal?

 

There are several reasons why Catalonia is pivotal to Spain and, therefore, why Spain is unwilling to allow the nation to secede. These include, but are not limited to, cultural, geographical, economic, and political. Despite a popular desire for secession, the contentious nature of the debate and referendum indicate that many individuals want to remain a part of the Spanish nation and European Union member state. This is likely to be because, ultimately, despite whatever the future holds for both Spain and Catalonia, they have shared an intricate history. The cultural and social ties across the potential border would inevitably be severed.

 

Geographically, Catalonia occupies much of the affluent border with France. With the Pyrenees creating an impasse across much of the border, the corner access point within Catalonia is critical. The potential to lose an area of strategic geographical significance, both in terms of trade and individual utility, is threatening for Spain. The political will for the nation to remain ultimately harks back to a realist defence of safety in numbers and solidarity with neighbours. The potential divorce of Catalonia from Spain would upset the current status quo of fiscal obligations and arrangements, threatening to stagnate politics and remove critical offices.

 

Evidently, economic reasoning is argued to be the most salient factor motivating the exaggerated market responses. Representing around 20% of the GDP of Spain with over 7.5 million inhabitants, the significance of Catalonia, from their fiscal contribution to their purchasing capacity, is a highly valuable national economic attribute. The attractions within Catalonia, not least Barcelona, draw high volumes of tourists each year, bringing a boost to the economy of Spain and the surrounding areas.

 

In part two of this article, we analyse why the Catalonian question is important to the Euro and foreign exchange markets:

Presidential Showdown: Trump-Erdoğan

Discussion and analysis by Grace Gliksten:

 

A month of souring relations with the EU has ended with Turkey in a stalemate with the US following a mutual suspension of visas. The Turkish Lira has unsurprisingly been hit harder by the event than the US Dollar which, surprisingly, still showed a perceptible weakening.  

 

Following the arrest of Metin Topuz, a Turkish employee of the US embassy, last week, relations between Turkey and the US have worsened, precipitating a vicious tit-for-tat reciprocity. While the Turkish government has provided no information concerning the arrest, the Turkish media has conjectured that Topuz was arrested for ‘facilitating the escape of known Gulenists’, followers of Fethullah Gulen whom Turkey accuses of being behind last year’s coup attempt. Visas were suspended mutually between the two countries despite the healthy diplomatic stance that both leaders displayed regarding their mutual foreign policies last month. The US ambassador has insinuated that certain Turkish officials were trying to unsettle relations between the countries while the Foreign Ministry in Turkey has claimed that the suspensions have shown ‘unnecessary victimisation’.

 

Relations between the two countries have been tense since the Obama administration and have slowly become deeper, despite the initial assurance from Erdogan that mutual cooperation could flourish. Erdogan believed that, under Obama, the US was too supportive of the Syrian Kurds, whom he believes to be an extension of the Kurdistan Workers’ Party, or PKK, which both countries have designated as a terrorist organisation. Moreover, the Turkish President was aggrieved by the failure of the US government to extradite Gulen upon Turkey’s request, despite US officials claiming the evidence provided by Turkey to be insufficient.

 

Whilst being marked as one of the worst performing currencies of 2016, the Turkish Lira found itself in new territory, strengthening against the US Dollar for seven months in a row this year. The Lira increased by 8.49 percent between February and August 2017 for the first time since the currency became convertible in 1989, likely on the back of tightening monetary policies that signalled the sensibility of the Central Bank of the Republic of Turkey and an increased reward for investment. The Lira began depreciating against the US Dollar in September after Angela Merkel’s calls for an end to Turkey’s membership bid; a trend also reflected within the Euro and Pound Sterling. Talks between the EU and Turkey have been left frozen for some time now, with EU officials growing worried that Erdogan’s Turkey is becoming more and more authoritarian under his rule.

 

Two year graph of USDTRY, GBPTRY and EURTRY: Exchange rate of the Turkish Lira in US Dollars, Pounds Sterling and Euros respectively in the medium-long run. The Turkish Lira is shown to be at seven-month-long highs against the US Dollar between February and August 2017. Despite periods of Lira strength against the Euro and the Pound Sterling, a similar, elongated, trend cannot be found.

 

The EU is, however, stuck between a rock and a hard place when it comes to rejecting Turkey’s membership bid. The EU has a crucial refugee deal with Turkey whereby Turkey has helped stem the flow of refugees trying to enter into Europe since the beginning of the crisis in 2015. Hosting almost 3.5 million refugees, surpassing any EU member state and accounting for almost three times the number in Germany. Erdogan’s apparent commitment to his agenda is causing the EU further concern. The referendum in April, won by a narrow 51.4 percent of accepted ballots cast, granted Erdogan new powers, adding to fears that Turkey will snowball into authoritarian rule. This includes the power for the president to intervene in the judiciary and the scrapping of the job of prime minister. The new system could see Erdogan in office until 2029.

 

The Lira hit 12-week lows this week against an already appreciating US Dollar. The Lira depreciated by 3.6 percent against the US Dollar and by 3.88 percent against the Euro on Sunday night. The significant depreciation was caused by to the combined effect of strengthening the perception of Turkey as an undemocratic and insular nation, as well as a pricing in of lower future demand for Turkish Lira by US citizens. The US is the fifth biggest market for Turkish exports, while Turkey only makes up 2.1 percent of US exports. Although minimal, there was a small effect on the US Dollar, shown in the differential between Lira crosses other than the Dollar and the USDTRY spot exchange rate. This can be attributed to two factors. Firstly, the demand for US Dollars in Turkey will have decreased due to the mutual visa suspension. Turkish nationals formerly travelling to the US may no longer need US dollars, weakening demand.  Secondly, there will be a natural, albeit small, effect on confidence within the US Dollar, because the diplomatic actions between the US and Turkey are mutual; just as US visas are to be withheld from Turkish citizens, so too are US rights to Turkey.

 

 

One week graph of USDTRY, GBPTRY and EURTRY: Exchange rate of the Turkish Lira in US Dollars, Pounds Sterling and Euros respectively in the short term. The amplitude of the US Dollar change is smaller than its Euro and Pound Sterling counterparts.

 

The relative importance of the Lira to the Dollar is minimal, shown by the negligible percentage change between the US Dollar and the Euro.  Analysing the net effect of Dollar weakness stemming from Turkish sanctions against US visitors is futile because of both the trading and political significance of Turkey to the US. As a major international reserve currency, a mark of stability, and a conduit for international trade, there is ample demand for the US Dollar outside of Turkey. As the same can’t be said for Turkey, the Lira took a far bigger hit.