With Great Power

Last Thursday, the European Central Bank undertook and presented what is, and what will be, arguably their most important monetary policy decision of this year. In keeping with the dominant theme from the Governor who hasn’t raised rates since he took office in 2014, the monetary policy decision was vague, dovish and resulted in an unsettling sell off in the Euro and underlying debt/derivatives.

 

The decision was so widely anticipated largely due to a churning of the rumour mill following disturbingly hawkish comments from the ECB’s chief economist, Peter Praet. The bank’s chief eyes and ears suggested the ECB’s feverish debt accumulation, that was initiated to insulate the Eurozone economy during and after the European Sovereign Debt crisis, is now redundant and ought to be pulled back indefinitely.

 

Given that net asset purchases still run wild at an accumulation rate of 30bn Euros worth of corporate and sovereign debt each month, the comments were probably overdue. However, in the context of an assumedly perpetually dovish European Central Bank, the rumour mill did generate a considerable bid and buying episode behind the Euro.

 

Draghi’s subsequent decision did, as foreboded by the chief economist, discuss both the near turn outlook (pace) for the tapering of quantitative easing and its eventual extermination. However, in true arch-Dove fashion, it was achieved in the slowest, most elongated and laborious way possible by the Euro Area monetary authority.

 

Dragging his feet, the bank’s governor announced that net asset purchases would fall to 15 billion euros per month whilst keeping the reinvestment of matured bonds and debt at 100%. Moreover, given that the ECB has deified the concept of sequencing (whereby interest rates cannot move before the QE program is culled), Draghi pushed back expectations for the first-rate hike until nearly the end of 2019. In a ‘deliberately vague’ wording, the ECB’s top dog and 8th most powerful man on the planet (Forbes) put his name behind stagnant interest rates, at least through the Summer of 2019.

 

The QE program will end up being just shy of a 2.4 trillion Euro experiment to save the Eurozone. And, my gosh, it’s success, despite resting upon dubious academic and industrial grounds, can hardly be knocked! However, the program does, and will continue, to flood the market with excess above-equilibrium demand for European public and corporate debt instruments that would otherwise not exist. As such, it puts immense downward pressure upon debt yields (making the raising of capital for treasuries and corporates considerably cheaper) but also immense downward pressure on the single currency, the Euro.

 

Draghi’s taper was delivered, but only in the most reluctant and cautious way possible. Given that markets had expected a little more in the face of Praet’s comments and a long consideration of the Eurozone economy, the Euro tumbled by over 1.5% against the Dollar. The Euro therefore continues its fall against its international counterparts, however, as it simultaneously (de facto) becomes cheaper and its underlying assets more competitive, so too does inflationary pressure and the hope of, finally, a hike from the powerful man, who won’t use his powers!

 

 

 

Discussion and Analysis by Charles Porter

 

 

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Overpriced Sterling

Following weeks of political and economic tumult, the Pound is not out of trouble just yet. Having only just survived the FX week from hell last week, (which saw a slurry of economic data and no less than four interest rate decisions across the globe), Thursday’s Bank of England decision stands as a great obstacle to Sterling. Having disappointed markets in May on the back of near stagnant first quarter UK growth, all eyes will once again return to Dr Mark Carney. As if that was not enough, investors will have the opportunity to cast judgement on UK Politics as the Bank of England Governor and the Chancellor of the Exchequer speak at this week’s annual Mansion House speech.

 

The Pound’s resilience has been tested to breaking point with three thoroughly disappointing Brexit singularities dominating headlines in the past two weeks. As David Davis appeared to stand at loggerheads with his party leader and Prime Minister, Theresa May, Sterling sold off dramatically.

 

Unsurprising, the Pound Sterling has reacted strongly to all things Brexit. Besides monetary policy developments, particularly towards the end of 2017, arguably the only significant driver of the domestic currency is substantial Brexit development (c.f. Lancaster House and Florence speeches). The EU Council Summit on the 28th/29th of this month has Brexit written right into the heart of the agenda. Accordingly, Prime Minister May was due to deliver something truly meaningful and significant towards the impending deadline on 29 March 2019. The subsequent denial of this promise was the Pound’s first stumbling block.

 

Secondly, only a few weeks ago, the Secretary of State for Exiting the European Union supposedly considered resigning from his esteemed and revered position. The debacle surrounded Davis’ strong objection to an open-ended Irish backstop proposal – a solution to the Irish border headache that would see the UK remain tied to the customs union to facilitate the incumbent trade arrangements alongside a so-called “invisible” border.

 

Thirdly, and perhaps most significantly, the Brexit bill’s tumultuous time in the House of Commons and ultimate failure before the House of Lords presented a real challenge. As the upper house voted against the present withdrawal bill by 354 votes to 235, the Pound gradually depreciated by more than 2% against an appreciating US Dollar, and ended the European Session below 1.32 for the first time this year. Against a somewhat more bearish Euro, the currency displacement was limited to only around 0.5%. The Brexit bill looks set for continued defeat in the House of Lords until peers are convinced that MPs have a meaningful vote on the final, or perhaps any, deal struck with the EU.

 

The risk facing the Pound should not be understated. Another at least tripartite offensive is threatening to undermine its value. First and foremost, the weakness of the trade weighted Pound Sterling spot index is largely driven by Brexit uncertainty amidst a widely jittery market. With global markets distracted and even infatuated by a transpacific trade war, yet more political uncertainty is dissuading potential investors to the Pound, no matter what premium markets are generating within it. As such, the fast approaching EU summit, which confers the continued propensity for yet more frustration on the topic of secession, creates even greater risk within the Pound.

 

The second danger looming over the Pound was the Bank of England Rate decision on Thursday and the curse of the unreliable boyfriend. Prior to the decision, markets were attaching an implied probability of a little over 50% for a 25-basis point hike at the monetary policy committee’s August meeting. Unarguably, the decision presented an immense risk to the Pound, particularly when considering the bearish spin that the central bank had tended to create within the Pound so far this year. However, an implied probability of 50%, alongside survey data that similarly suggested that approximately 55% of market participants expect an August interest rate hike, seemed far too low.

 

Key guidance from the bank of England last year suggested that markets continue to considerably under-price the probability of an interest rate hike in the coming months. Pricing action within bond markets and the spill-over in FX markets does seem under-priced. However, with only strong retail sales data supporting the Governor in the short-run, it is unsure whether the MPC can truly afford to raise rates any time soon. A 6-3 split within the committee placated markets slightly despite a dovish spin in the subsequent press conference. Cable traded as high as 1.33 following the decision, however, markets appear to be unsure whether an August of September hike is on the cards.

 

Last but not least, but certainly most scarily named, the death cross looms. Within the rapidly depreciating GBPUSD cross, the 50-day moving average has, for the first time yesterday, overlapped and passed through its 200-day moving average. The technical indicator is very popular despite having a highly mixed series of academic and professional endorsements and evaluations. We will await to see if the moving averages only kiss briefly, providing only a scare to the Pound, or continue the bearish paradigm that the Pound may have entered into. As investors hold their breath and hedge their risk far and wide, I’ve just sold my Sterling for next month’s travels!

 

 

 

Discussion and Analysis by Charles Porter

 

 

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