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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.



Weekly Noteworthy Trends

Discussion and Analysis by Charles Porter:


The week to date has seen a reversal of some incumbent forex market trends. Whereas the tripartite combination of Dollar weakness, Sterling (post-Brexit relative) strength and Euro strength seemed entrenched a few weeks ago, new dynamics are prevailing. Particularly, the Dollar has regained considerable value against the Euro and, even more so, the Pound Sterling over the past couple of weeks, with an accelerating rate of appreciation. The post-Brexit highs that the Pound hit against the Dollar, and to some extent the Euro, have been gradually unwound, leaving Sterling trading at weekly lows against the Dollar and Euro. This article analyses why and demonstrates the extent of these shifts.


Overwhelmingly, the most decisive currency market movements this week have been those exposed to the Pound Sterling. Particularly, the Euro and US Dollar crosses both show considerable strength against the Pound. Depicted below, the week-to-date change in value of the Dollar and Euro against the Pound Sterling is 1.75% and 1.32% respectively. Amidst the two movers, the Dollar has seen the most sizeable recovery against the Pound, and, against the Euro, Sterling has gained a little over one half of one percent.


Whilst the geopolitical challenge of North Korea has far from subsided, the risk-off strategy prevailing throughout markets sporadically over September has all but disappeared. While US assets, from equities to bonds, show a diminished sign of deliberate investor avoidance, the demand for developed currencies has spurred, allowing the US Dollar, in particular, to appreciate. Moreover, the lack of data sensitivity as we approach tomorrow’s labour market report will allow the US Dollar to retain value whilst hard data seem in-credible, should any downside risk manifest.


Meanwhile, on the European continent, political uncertainty has far from diminished. Following the independence vote within Catalonia, the legitimacy of the Spanish government and European institutional capacity is threatened. A break-up of the Eurozone is far from in the question; far greater crises have come and gone. However, with President Macron of France and the newly mandated Chancellor Angela Merkel of Germany presenting a whole new pro-integration potential within the Eurozone, the public permissibility of their intentions may be threatened.


Similarly, on the European continent, the Political Economy of the United Kingdom looks threatened, or certainly unstable in the medium run. Consolidation and progress following the exercise of Article 50 of the Lisbon Treaty looks minimal, with the fifth round of Brexit negotiations, due to commence next week, still barred from considering the future relationship of the UK and EU. Therefore, the week-to-date retraction from the Pound Sterling amidst stagnation and pessimism is understandable.


Today, especially, the US Dollar has gained significant ground against the Euro. This gain has also carried over into the Pound Sterling that demonstrates intraday Euro weakness as well as Dollar Strength. Whilst the Euro’s weakness is still explicable with reference to the uncertainty within Spain, Dollar strength is achieved by an adherence to monetary policy tightening and speculation surrounding Trump’s GDP and commercial-friendly tax plan intentions. The campaign for Trump’s inaugural policy commitment is far from young. However, confidence in the capacity to achieve, and commitment to pursue, such a policy is in its adolescence. Overall, it appears that confidence in the Trump administration may facilitate a re-realisation of the gains that the US Dollar made whilst the incumbent President was only Elect and immediately after his inauguration.

Retail Data Drags Dollar

Discussion and Analysis by Grace Gliksten:


In the UK overnight trading session, a further blow to the Australian Dollar was dealt by the retail market, further highlighting the importance of the decision by the Reserve Bank of Australia, RBA, to hold interest rates at 1.50 percent. Philip Lowe, governor of the RBA, claimed the bank would wait until consumer spending strengthened and wage growth increased before reviewing the rate. This data dependency exacerbates market reaction to macroeconomic statistics releases.


Data from the Australian Bureau of Statistics (ABS) showed retail sales dropped by 0.6 percent in August, down for a second month in a row, despite a consensus forecast for a 0.3 percent rise. All Australian retail categories saw a decline in sales through August with the exception of department stores, which saw a small increase. In the worst decline since October 2010, July and August also showed a 0.8 percent, highlighting the fragility of the Australian economy.


The decline in retail spending has been attributed to low real wage growth, which has halved in the last five years. Coupled with rising debt in the Australian housing market, the ability for consumers to spend has been limited. These figures alone should not be read into too deeply. However, they achieve more bearing when coupled with retail figures for August. This paring reveals a more systemically unhealthy economy with car sales, as well as poor real estate data, painting a bleak picture of the Australian economy.


With the decision to raise interest rates in Australia proving to be pivotal, the RBA is assigning excessive impetus to macroeconomic data. Therefore, worse than expected retail performance results are one of the factors holding the RBA back from raising interest rates. The interest rate is a monetary policy tool used to manipulate the macroeconomy. Interest rates represent the reward for saving and the cost of borrowing money within the domestic economy.


Philip Lowe most recently announced that the global economy really is firming up. This followed a string of developed markets central bankers declaring that the macroeconomic risk across the world is declining. The concern within the Australian economy is that idiosyncratic national risks still exist. In effect, therefore, the Australian economy is not feeling this recovering. The disparity between the global and Australian economies underlies the exchange rate sensitivity to a variable that really shouldn’t matter on the national stage; retail data.


The Australian Dollar weakened against the Pound Sterling and US Dollar during the data release at 1:30am BST. The weakness derived from retail data briefly undermined the week long high the Australia Dollar was trading at, at the point of release. This data helps illustrate an underwhelming Australian economy, further highlighting the cautious position the RBA is taking in holding interest rates, predicted to last until next year. The move to hold interest rates, leaving them at a record low, acts to disincentivise outside investors from increasing their exposure to the domestic currency and economy, whilst also preventing confidence in the economy from building. Only a maturation and elimination of dwindling confidence concerning the Australian Dollar will correct against the Aussie Dollar’s relative weakness against the US Dollar since mid-2011.


Australian Dove

Discussion and Analysis by Grace Gliksten:


For the fourteenth month in a row, the Reserve Bank of Australia, RBA, has left the Cash Rate on hold at 1.50%; a trend that seems unlikely to change in the coming months, due steadfast adherence to a neutral bias. Unsurprisingly, the Australian Dollar reacted negatively. Surprisingly, the response was moderated and shortlived…


Continuing the global optimism he displayed in September, the RBA Governor, Philip Lowe, introduced this month’s Monetary Policy Decision by saying that ‘conditions in the global economy have improved’. Lowe also showed partial optimism for the Australian economy by highlighting the 0.8% growth in the June quarter and acknowledging the employment growth over the last few months.


Amidst the stagnation of the construction and mining sectors, Lowe even proclaimed that ‘non-mining investment is picking up.’ This is particularly significant given last week’s speech from the Head of the Treasury’s macroeconomic division, Nigel Ray, who claimed that Australia’s most influential economic event has been the mining boom; claiming it to be more influential than the global financial crisis.


Lowe’s optimism did not come without concern. For example, the Governor highlighted that wage growth had remained low and was expected to continue that way for some time. In the five years since the mining boom’s peak, the average wage growth has declined by over 1%. When inflation is taken into account, real wage growth has halved. Taking a more pragmatic stance on low wage growth, Scott Morrison, Treasurer, said in a speech last week that, ‘in Australia, wages growth has been heavily impacted by mining investment boom washing out of the system, as the economy attempts to rebalance itself from the extraordinary terms of trade boom that fuelled our nation’s prosperity for almost a decade.”


The decision to hold rates had a moderately significant effect upon the Australian Dollar-Pound Sterling currency cross. The interest rate is a monetary policy tool used by central banks to manipulate the macroeconomy. Representing both the reward for saving and the cost of borrowing, interest rates can manipulate the attractiveness of prospective domestic currency exposures.


Philip Lowe’s central bank chose not to change interest rates, thereby leaving the cost of borrowing and reward for saving at a record low. This has a two-fold effect on the Australian Dollar and economy. Firstly, by not raising interest rates and raising the reward for saving and investment, outside investors are disincentivised from increasing their exposure to the domestic currency and economy. Secondly, by keeping interest rates at record lows and refusing to increase them back up to ‘normal’ levels, confidence in the economy is prevented from building.


The salience of the secondary, confidence-based, effect is building. The market has begun to heavily price a before-year-end rate hike from the Bank of England as a base case scenario. Meanwhile, the Federal Reserve Bank has heavily signalled its intention to taper its bond purchasing programme, quantitative easing. Moreover, the European Central Bank is already looking to start its sequenced monetary policy tightening procedure. The global move towards a tighter monetary policy could potentially see Australia falling behind, with expectations stagnating around the RBA continuing to hold the interest rate until the fourth quarter of next year.


At 4:30am BST a spike in the value of the Pound Sterling against the Australian Dollar is clearly visible. This event is whilst markets price out the upside risk of an interest rate hike. This is then seen to deteriorate throughout the day, which can be attributed to Pound Sterling weakness, most apparent when the Aussie Dollar is compared to the US Dollar/Pound and Euro/Pound currency crosses. By market close, the trading value of the Australian Dollar was roughly where it has started at the beginning of the day.


EU banner

Puigdemont leads Catalonia out

Discussion and Analysis by Grace Gliksten:


This article discusses the implications of Catalonia’s independence referendum over the weekend. Following a period of considerable Euro strength, the political uncertainty threatens to halt its gains and shroud the Eurozone economy within doubt.


Falling somewhere between a centrist and a social democrat, Carles Puigdemont started his political career relatively late. He was elected a member of the opposition at Girona City Hall in 2007, followed four years later by his promotion to elected mayor. In 2016, Puigdemont won a vote of confidence in the Catalan Parliament to be named the new President. Born in 1962, Puigdemont worked as a journalist, having dropped out of University. Puigdemont began his political career in the 1980s, founding the Girona district of Juventut Nacionalista de Catalunya.


Puigdemont has been fighting to establish an independent Catalonian state since he took office in January 2016, calling the referendum in June. The second manifestation of this dream gripped markets early this week, damaging Spanish equities and bonds with a mild spill-over into the Eurozone. A fanatic about Catalonian independence; he told Al Jazeera that the wish of Catalans to execute the forbidden referendum “is unstoppable”.


Over the last six years he has been involved in organised demonstrations, and was a protagonist in the last referendum for Catalonian independence, in 2014. Although there was an 80% vote in favour of independence in 2014, the turnout was a meagre 37%. Whilst the most recent referendum has been more decisive in terms of turnout and result, it still paints a picture of uncertainty about the true will of the electorate.


The character and background of Puigdemont individually may prove critical to markets in the next 24 hours. Should the President of Catalonia declare independence following this controversial referendum, the uncertainty effect derived from an area accounting for around 20% of Spanish GDP becoming independent could be catastrophic. It would draw in concerns of fiscal sustainability, both with respect to Spain and Catalonia. Although less salient, the budgetary contributions and fiscal burden sharing within the Union would be upset.


Puigdemont’s involvement in the most recent referendum has not come without risk; Spain’s chief public prosecutor has even refused to rule out ordering the arrest of Catalonia’s president, adding Puigdemont could be charged with civil disobedience and misuse of public funds. Pushing two illegal and non-binding referendums in three years shows a level of desperation by the Catalan government’s fight for independence. Turnout was only 42%, which although roughly 5% up from the referendum three years prior, does in fact indicate that the results do not represent the true desires of the electorate.


Given Puigdemont’s involvement in organised demonstrations, the first, failed, Catalonian referendum and antagonising comments, we might expect his fanaticism regarding independence to guide his political actions. The political power to invoke an independence claim lies with the President. Ultimately, therefore, we may expect his individual motivations to exploit what is a weak, contentious and unconvincing mandate to achieve independence from Spain. While the idiosyncrasies of this weekend’s referendum may be considered by some to mitigate against the illegality of the referendum and mandate generated therein, Puigdemont represents a considerable political risk in himself.


Whether the reasons people did not come out to vote were down to the fear surrounding the harsh response from the Spanish police or the illegitimate feeling projected by the Spanish government, it is not clear. The Catalan Government are suggesting that 770,000 votes were lost as a result of police crackdowns, however taking this figure into account only pushes the turnout to just over 50%. It can still be argued that only 37.36% of the overall electorate voted for independence, which again further illustrates the illegitimacy of the independence result. According to a June poll, support for an autonomous Catalan state has fallen from 44.3% in March to 41.1%.


Without a true and legal referendum, the views of the people will not be truly understood. What is clear is that Spain’s complicated relationship with Catalonia is headed towards the unknown. The harsh police response, coupled with the threats of suspending Catalan autonomy if the decision did come through, can be interpreted as a deep-rooted fear by the Spanish government in the people of Catalonia voting to become independent from Spain. However, this could also be a situation of a politician representing their own ideals instead of the electorate as a whole. Puigdemont’s humble and local beginnings can be used to understand his strong belief in an independent Catalonia, however can also show his inability to understand the real attitudes of the electorate.


Ultimately, the progression of the Catalonian independence referendum reinstalls political risk at the heart of the Spanish nation, European Union and Eurozone. Should Puigdemont capitalise upon the success which he attests to, considerable political and social fall out, within and without the region, should be expected. Ultimately, this develops investors’ unwillingness to operate within the single currency, particularly the Spanish economy. Identifying whether the resilience and capacity for risk sharing embedded within the Eurozone is sufficient to annul or insulate this crisis from the wider macroeconomy will be a critical when evaluating the impact of Catalonia’s referendum.