Caught in a Trap

 

A minor weakness in the Euro over the last week has helped to propel the GBPEUR cross to the precipice of the psychological 1.16 barrier. A potential fatigue arising across the Eurozone for concession building and monetary, fiscal and economic integration is one of the main reasons behind the decline.

 

On Tuesday, the rate of the Euro against one-Pound Sterling rose to just one hundredth of one cent away from a trading value of 1.16. Reaching and sustaining for a while a value of 1.1599 represents the highest value of the Pound against the single currency in over twelve months. Against the Dollar, however, the Euro story is not so remarkable.

 

In the world of hyper low volatility that we have experienced recently, characterised by a stagnant and low VIX and negative real yields on developed market debt, channel trading has become all too familiar. Accordingly, the Euro generated its own channel trade against the Dollar:

 

 

2017 was strongly and unequivocally characterised by a systemically weak Dollar and, in the most part, an outperforming Euro. Having struggled to confidently sustain its break through 1.25 Dollars to the Euro, EURUSD has generated the channel trade depicted above.

 

Following a climactic end to the year that exaggerated the existing trends that had preceded it, the Euro broke through the low of 1.20s to the Dollar. However, since January, Euro-Dollar has comfortably contained its parity between an upper bound of just in excess of 1.25 and a strong floor of 1.22. Following a sustained paradigm of Euro strength, there now exists a political challenge with the theoretical salience to stunt the Euro’s performance considerably.

 

The centrist French President Emmanuel Macron has long since voiced his passion for the European project and, more importantly, Eurozone integration. The newly proposed budgetary capacity for a previously non-redistributive Union is ground breaking and proposed as a strong antecedent to a functioning and strong monetary union, of which the Euro is a prime example.

 

The ambition and scope of the proposed reform cannot be understated; it would, in my opinion, require a complete overhaul of both the EU treatises, the acquis communautaire, and conceivably the entire legal foundation of the economic and monetary Union. Critically, this is not impossible and, in the name of longevity and success, may be a requirement in the long run. However, what would turn a crazy idea into an unrealisable one is a lack of political will to follow the Macron’s initiatives within the Union. This is the situation we face.

 

On Tuesday, Merkel made the position of her CDU/CSU bloc overwhelmingly clear: Germany is not on board. Dependent upon the priced importance of a fiscal insurance mechanism behind the Euro, the denial of Macron’s reforms could be extremely harmful to the Euro over the long run. Of course, markets are always trying to get ahead of themselves due to the desire of the individuals that populate them to be one step ahead of the curve. Unsurprisingly, therefore, when Mr Macron visits Berlin later today, any negative news could still have short run negative effects to the Euro.

 

 

 

Discussion and Analysis by Charles Porter

 

 

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Deflated

 

At 09:30 yesterday morning, the Pound was in momentary free fall as investors priced out the positive risk of an increase in interest rates in May and into 2019. As the imperative monetary policy decision on the 10th May draws ever closer, analysis and qualifications of future inflation expectations will be highly salient to the value of the Pound.

 

As a headline figure, consumer price inflation will not be read again ahead of the much-anticipated meeting of the monetary policy committee next month. In fact, the only major data release standing between now and the decision itself is a reading of economic performance, as measured by gross domestic product, on the 27th April. Instead, perhaps investors will be focused upon a finer evaluation of yesterday’s data.

 

At first glance, prompting the Pound’s major decline, was a downward shock to consumer price inflation by 0.2%. Inflationary pressures were expected to subside following the Brexit decision as statistical effects of a weaker domestic currency on a year-on-year basis began to normalise. However, as domestic inflation, particularly within the more transparent and reactive service sector, continued to exceed the Bank of England’s 2% target, expectations of monetary policy normalisation began to support the Pound.

 

When these expectations first materialised in November 2017, the Pound was rescued from its paralysis and free fall towards a value of parity against the Euro. Hitting a low of 1.0745 only a couple of months earlier, the rescue of the Pound was much needed and shouldn’t be underplayed.

 

The latest reading of CPI inflation was recorded at 2.5% year-on-year, down from 2.7% the previous month, and a high above 3% only a few months ago. When looking at core inflation, a measure of the domestic price level ignorant to more volatile components that its general counterpart includes, the fall was just as dramatic. Whilst March’s reading of February’s year-on-year core inflation was recorded at 2.4%, dominant consensus expectations had surrounded on 2.5% as the level of core inflation within the UK economy. The publication of 2.3% year-on-year CPI inflation yesterday morning was therefore met with a strong sell off of the Pound.

 

Within one minute, the rate of the Pound against the Euro had fallen from a value approximately in line with its market open value of 1.1550, down to 1.1490. Against an appreciating Dollar, the move was even more pronounced: despite trading at 1.4275 only seconds earlier, the statistics release wiped just shy of one cent off of the pair, to the detriment of the Pound. On a trade-weighted basis, the value of the Pound fell unilaterally by around 0.55%, with the effect against an outperforming Dollar being exaggerated to in excess of 0.75% within the cable rate.

 

Within the more detailed report, evidence remains that yesterday’s result may have been a freak result. Due to the intrinsic domestic orientation of the majority of any service sector, it remains the strongest barometer of true inflation, void of external influence from global trade and the exchange rate.

 

Service sector inflation even rose from 2.5% from a previous reading of 2.4%. There remains the strong possibility, therefore, that the Bank of England holds onto its forecasted intentions to raise rates during its May meeting.

 

Today’s sell off in the Pound represented the pricing out of risk within the value of the Pound for an increase in the reward for saving and the cost of borrowing. Perhaps, due to a trading reaction to the headline CPI figure, the dynamics of UK inflation and monetary policy had been over estimated yesterday. As such, there remains a strong possibility that at least from the side of pure economics, there could be an upside to the Pound in only a few weeks. As Theresa May met with her counterparts from across the Commonwealth of Nations yesterday evening, the topic of post-Brexit trading relationships could dominate the political scene and value of the Pound.

 

 

 

 

Discussion and Analysis by Charles Porter

 

 

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Morning Glance

 

Following yesterday’s chronic bout of Sterling weakness, the Pound has opened weaker for the second consecutive day this week. Yesterday evening saw the heads of state of Commonwealth nations gather together at an event in London hosted by the UK Prime Minster Theresa May. As the market opens this morning, investors appear uncertain whether the UK made headway in under the table trade negotiations last night. According to the draft transitional agreement, the UK may negotiate its own trade negotiations, although not implement them, during its transitional phase. With Brexit day less than a year away, any informal news about last night’s meeting could prove positive for the Pound.

 

Globally, two interesting notes appear from emerging markets: South Africa and Turkey. In South Africa yesterday morning, March’s reading of Consumer Price inflation was published. The publication showed that annualised consumer price inflation for March was just 3.8%, exaggerating its decline further. Following an interest rate cut by 25 basis points at the central bank’s last meeting, low CPI inflation is not what was prescribed for South Africa’s economy. Whilst the Rand held relatively strong during yesterday’s trading session, the statistics do create cause for concern about the future path of monetary policy.

 

In Turkey yesterday, the declaration by President Erdogan of a snap election rallied the Lira. The move by Erdogan represented an opportunistic attempt to consolidate power while domestic growth and political satisfaction is acceptable. The Lira gained 2.5% against the Dollar, rallying to a rate of just shy of 4 Lira to the Dollar.

 

 

 

 

 

 

Discussion and Analysis by Charles Porter

 

 

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Rose Tinted Spectacles

 

The European sovereign debt crisis that gripped the eurozone at the beginning of this decade has left the bloc with rose tinted spectacles. During the crisis, the economic performance of key Eurozone member states tumbled considerably. Shown in the Graph below, the economic growth rate within previously flourishing and affluent member states tumbled during the crisis. In fact, only the fiscally sustainable nation of Germany, with an infatuation towards a balanced budgets and structural austerity, survived relatively unscathed.

 

 

More than headline national accounts and gross domestic product, the crisis hurt citizens: the rate of youth unemployment doubled in a matter of months, converging around 20% in Ireland, Greece and Spain. This woeful economic performance coincided, and contributed to, considerable social and political unrest; two phenomena that are particularly business UNfriendly! However, as business conditions eased, and economic growth returned several years into the decade, the tide started to turn on confidence and investment. Now though, the trend appears somewhat overbaked!

 

The Euro has rallied impressively throughout 2017 and 2018 to date. Having survived numerous and high salience national elections, the Euro remains poised for a strong and sustained appreciation in the eyes of many investors. However, economic confidence may appear to be on the turn.

 

Economic confidence indicators are labelled as ‘soft’ data, due to their reliance upon sentiment and survey data. The data consistently proves to be more dynamic and reactive to economic movements than traditional hard data and national account. Admittedly, the data often comprises of considerable noise. Despite the limitation of sentiment-based indicators, they do have a fundamental and inalienable correlation with economic performance and more lagging hard data. As such, they still confer a high salience and the capacity to move exchange rates.

 

Following the remarkably poor economic performance during the European sovereign debt crisis described above, the purchasing managers are viewing the Eurozone with rose-tinted spectacles. The Eurozone soft, sentiment-based, data stands close to an all-time high, despite the underwhelming political and economic landscape. Worryingly for the Euro, the sentiment-based data may be on the turn:

 

This week, yesterday, vast purchasing managers’ index (PMI) data was released, providing a timely update on the Eurozone economy. At the national level, the composite performance in Italy and Germany fell considerably. Moreover, across the entire Eurozone, services and manufacturing indices underwhelmed expectations and fell at the aggregate level.

 

Accordingly, the Euro has underperformed towards the end of this week, weakening up to 1.1460 against the Pound this afternoon and falling as low as 1.2215 against the Dollar. As Federal Reserve chairman Jay Powell speaks this afternoon following extensive labour market data in the united states, the latter currency pair, EURUSD, could be a pivotal pair.

Heads or Tails

 

The Pound Sterling has flipped back and forth from an infatuation with politics, to an inescapable reliance upon economics. The phenomenon is partially responsible for creating the unprecedented channel trade that GBPEUR has crabbed along over the last six months. Supported at a little above 1.1050 on several occasions in October, the GBPEUR cross finally confidently found its way through 1.15 last month.

 

Not for the first time, it was economics and the Bank of England that provided the final push of positive fortune for the pair. The rally was short lived and saw the Pound come to be worth 1.1530 Euros following a monetary policy decision to hold interest rates at 50 basis points. Interest rates are pivotal to the value of an individual currency, not least due to their centricity to the domestic economy and near unilateral responsibility for determining the opportunity cost of holding money.

 

With a capacity to both determine the future path of the economy and provide a more accurate interpretation on the medium-term path that the economy has been on, it is no surprise that getting interest rate decisions right in the long run is imperative for the success of market participants. The secrecy and independence of central banks should not be taken for granted; whilst the Bank of England, the Fed, and the ECB might look quite similar at face value, beneath the surface they are remarkably different. The independence of the Bank of England was granted under former Labour Prime Minister Gordon Brown in 1997 on the back of much public and academic discourse and debate. Meanwhile, the European Central Bank had not even born yet and anything even resembling a Euro are banking system was still two years away at least!

 

At this present time, the constitution of the Bank of England is not too challenging. The decision that led to the first interest rate hike in a decade back in November was led by Governor Carney and strongly supported by the BoE’s two unequivocal arch Hawks, Michael Saunders and Ian McCafferty. Opposing them at most decisions are the two notorious doves, Dave Ramsden, a relatively new member to the Monetary Policy Committee, and the veteran Jon Cunliffe. Hypothetically, therefore, the outcome of rate decisions should not be too difficult to predict. With the salience of the decisions, however, this is never going to be the case:

 

At present, the Bank of England is debating a decision to publish more open and apparent signals detailing their intentions surrounding future monetary policy. Swaying towards the more open and transparent Federal Reserve in the US, the output of the Bank could be set to change dramatically as a result of the debate.

 

Markets are pricing in a 25 basis point hike next month, making the debate even more salient. It is highly possible that if the expectations surrounding the decision on the 10th of May are met, Sterling will rally in the third notable BoE rescue of the Pound in the last year. Critical to this result would be the mention of a sustained commitment to policy normalisation over the next couple of years. However, if the reality falls short of present expectations without a future commitment or indication of an imminent hike, GBP could tumble. The Pound currently trades around 1.4050 against a US Dollar that has been caught up with trade disputes.