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Brexit under May


Discussion and Analysis by Charles Porter:


The original Brexit vote was motivated by a dissensus within the incumbent Conservative government under David Cameron; at least that is the public and academic consensus. I argue that this suggests that the delivery of a final secession, and the eventual form that Brexit takes, will be definitive and complete. Whilst the media and critics may fear and criticise Theresa May’s commitment to a soft or incomplete Brexit, even her conjectured ambivalence about reversing the process entirely, the composition of the Conservative party is likely to force her hand to abide by the will of the Leave vote.


The market’s short-medium run consensus is bearish for the Pound, my view also remains this way. However, this article aims to uncover why this trend and expectations for its continuance might be over exercised and the bearish market over anticipated. Whether the desire for the United Kingdom to exit the European Union has been evolving and suppressed within the British public ever since 1973 is inconsequential. What matters is that the Brexit mandate is the democratic consequence of the June 2016 referendum; an event that was facilitated at this specific time by the internal dynamics of the incumbent Conservative government.


David Cameron’s Conservative party was staunchly divided on Brexit. This was not a new tension, or, for that matter, even one that has disappeared following Cameron’s resignation. Conservative MPs are almost equally divided on the matter of Europe. Whilst this numerically resembles the referendum divide, a geographical, voting result, and demographic analysis reveals that parliamentary representation does not correlate with public voting behaviour. Critically, therefore, the Conservative party is constrained.


To unite his party during the 2015 election campaign, Cameron included the pledge within the Conservative manifesto. There were additional reasons for this inclusion. For example, the wider conservative party feared a defection of voters and MPs alike to the United Kingdom Independence Party; UKIP. Therefore, in an appeal to the median voter and to develop the voter base during the referendum, the party offered a referendum, despite formally voting to remain. However, internal party dynamics were overwhelmingly responsible for the referendum opportunity, with a breakup of the party and defection possible had Cameron not conceded to a referendum. Critically, I argue that this division within the Conservative party will, once again, safeguard the deliverance of secession. This is because without a significant reshuffle of Conservative representatives, Members will assert pressure upon the leadership and cabinet to deliver.


This offers a critical market insight: despite public and media fears of a Brexit U-turn, so long as the Conservative party is the predominant government, a Brexit is almost a foregone conclusion. Therefore, upon the realisation of this conclusion, the uncertainty and risk that is priced within the foreign exchange market surrounding the secession negotiations and final exit arrangement could be alleviated. Uncertain effects surrounding the British political economy deteriorate the value and purchasing parity of the Pound Sterling. A potential for a partial revaluation, ceteris paribus, once this fact establishes itself is a strong possibility.


Ultimately, therefore, the Pound could be valued slightly higher than its respective intraday level by pricing out the uncertainty risk of a retrenchment from Brexit and a deliberate bad deal. As mentioned above, this does not reverse expectations of a bearish Pound Sterling. The absolute risk surrounding Brexit and the final exit deal still remains. Instead, what is overpriced, is the risk of a no B-Remain, a U-turn and the political and social fallout from this event.


This leads to the conclusion that despite rightful concern about Brexit negotiation progress and UK party politics, the constraint upon the government to execute a satisfactory and decoupled Brexit is stronger than one might realise at first glance. Following the devaluation of the Pound at market upon this morning, when Sterling lost more than half a percent against the Dollar and Euro, this message is increasingly salient.


While there are qualifications to this, not least the unstable absolute mandate of this Conservative government thereby raising the efficacy of defections, the Parliamentary and whip system can be supposed to offer some constraint upon Commons voting behaviour amongst Remain-inclined Members. Therefore, the only real threat to the foregone conclusion of a Brexit is a second referendum; a measure that the composition of the incumbent party should, once again, preclude. Members of the party would be constrained to follow their public mandate, however, have considerable power over whether to allow that mandate to manifest by blocking a referendum bill in the Commons.


In summary, regardless of your opinion on Brexit; good bad, beautiful or ugly, the UK’s secession from the European Union is almost inevitable. Outstanding circumstances outside the realm of normal governmental action and party politics would have to prevail with remarkable secrecy. The argumentation behind this conclusion further suggests that risk within the Pound Sterling, specific to Brexit, is overvalued. Therefore, the Pound Sterling may appreciate upon the realisation of the government’s real, de facto, commitment to leaving the Union. The Conservative party conference, that concluded yesterday, developed even more weight to this argument; Brexit is the only plausible option within the UK’s incumbent centre-right party.


Catalonia and the Euro:

Discussion and Analysis by Charles Porter:


It is indisputable that this weekend’s referendum in Catalonia generates considerable headline risk within Europe. The instability, uncertainty, and political risk within the Spanish economy has reflected within nationally sensitive equities and indicators. However, the purchasing power of the Euro, its exchange rate vis-à-vis other currencies, appears to be largely unaffected. The question of whether this relates to a systemic insulation of the Euro, or pure insignificance of the referendum, has a particular importance to those exposed in the Euro.


Opening down against the Pound and the US Dollar, the Catalonian independence referendum might have been supposed to undermine Eurozone solidarity. After all, should the independence of the region be declared, at least the form of the future Spanish and potential Catalonian membership with the Union and single currency should be questioned. However, the significance of the difference before and after this weekend’s referendum was only marginal. Interestingly, the weakness within the Euro against the Pound Sterling has been reversed throughout the morning, up to 10:00 BST.


The result attested to following the controversial referendum generates a considerable mandate for the region’s independence. The threat of a high-productivity and nationally significant region declaring formal independence from Spain creates uncertainty both within the nation and within the region. The uncertainty should be supposed to deter investors from both the region and the nation whilst the taxation revenue and spending distribution is re-evaluated and the future legal political framework of the independent region understood.


This uncertainty has been reflected within Spanish markets. Notably, yields within 10-year Spanish Government bonds has increased by nearly 5% since the close of markets on Friday. The yield on bonds and general debt reflects the inverse of the price of the bond. The yield is the effective return that the bond will pay to the investor and holder of the contract, qualified by its face value. It is clear, therefore, that if the return on a bond increases, it must reflect the risk of holding the contract; the risk of no repayment. Therefore, the increase in the yield of Spanish Government bonds is telling of the political uncertainty and credit-worthiness that the referendum has installed.


The spill over from the referendum was not contained within the sovereign debt market. Spanish equities, particularly banking stocks, were hit by the weekend’s events. The violence and reported atmosphere within Catalonia this weekend should be considered as a strong and concerning phenomenon that has exacerbated the scare within financial markets. Overall, the impact of the referendum has damaged the value surrounding the Spanish economy.


So, why has the Euro not been hit that hard?


Well it is possible that the exchange rate priced in the political risk of the foreseen referendum better than the bond market has. However, this is highly implausible given the transparency and comparability of the free markets of bonds and flexible exchange rates, not to mention their entwinement. Therefore, instead, I suggest that the solidarity within the single currency insulates the single currency from the idiosyncrasies of national concerns.


Naturally, a union of 19 national currencies should not be as responsive as a national currency to an upside or downside event affecting only one nation. Sharing a currency shares exchange rate risk, de facto, without explicit design; a currency union is effectively a fixed exchange rate. Therefore, because the Catalonian risk is unlikely to transmit across borders, at least in the medium run, the deserved foreign purchasing parity of the other 18 economies should, ceteris paribus, be intact. Ultimately, currencies are a conduit for which to facilitate international trade, mobility and engagement. As such they are an excellent indicator of the integrity and strength of an economy. Therefore, the risk that the Catalonian referendum generates is mediated and diversified across the other 18 nations, thereby preserving the value of the Euro.


For the risk averse individual purchasing international currencies, this suggests that the volatility of the Euro to political agendas should be limited. It could be thought, and has been proven to be so, that the US Dollar contains a similar stability and value. This is why these currencies are used, or increasingly used, as reserve currencies; conduits and mediums to preserve wealth as well as facilitate trade. For those seeking exchange rate upside and downside risk, the Euro and Dollar may be unsatisfactory currencies.



BoE Carney Speaks to IMF

Discussion and Analysis by Charles Porter:



Last week, the minutes published following the Monetary Policy Committee’s Decision rallied the pound sterling. This event triggered an appreciation of the Pound Sterling contributing to intraweek gains in excess of 3 percent. Moreover, the Hawkish conclusion delivered by Gertjan Vlieghe, a traditionally Dovish Committee member, signalled a sooner-than-expected rate hike that in turn cemented and developed these gains. However, Carney’s speech today was unable to re-value Sterling.


The analysis of Gertjan Vlieghe’s speech reveals that markets reacted strongly to the following inclusion:



“If these data trends of reducing slack, rising pay pressure, strengthening household spending and robust global growth continue, the appropriate time for a rise in Bank Rate might be as early as in the coming months.”



The above quotation conforms almost perfectly to the minutes of the Monetary Policy Committee’s minutes-guidance. Sterling appreciated on the back of this speech because it demonstrated Committee-wide concurrence even amongst the more hike-averse members. Therefore, should Carney place more emphasis to an imminent hike or deliver a more Hawkish conclusion, then a further appreciation should be expected to prevail. However, presumably, so long as Carney did not deliver an outstandingly Dovish message, Sterling should maintain its gains and price out any risk of intra-Committee disagreement.


Mark Carney, Governor of the Bank of England, delivered a speech to the International Monetary Fund this afternoon at 16:00 BST. Although offering an abridged version to the Fund and their guests, the full publication was available at 4pm and thus currency market movements after this time should reflect, at least in part, Carney’s speech.


Validating the above expectations, Carney did side with the Monetary Policy Committee, suggesting that:



“As the Committee stated last week […] some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target.”



However, the Pound Sterling did not appreciate at all against other currencies, including the Euro and the Dollar. This may perhaps be because Carney did condition against this conclusion:



“Any prospective increases in Bank Rate would be expected to be at a gradual pace and to a limited extent[…]”



Therefore, if markets had, arguably unreasonably, predicted a stronger monetary policy tightening, Carney’s words may have cased investors to sell off the currency. This is because the gains that they anticipated, which derive directly from a higher interest rate, may not be realised. Ultimately, the next monetary policy Decision at the beginning of November will prove, or disprove, the Committee’s intentions to raise interest rates.


The Week Ahead

Discussion and Analysis by Charles Porter:


The week that is now behind us has been eventful and tumultuous. One overarching characteristic was a bullish Pound Sterling. Driven by statistics releases and central bank activity, the Pound finished the week trading at its strongest rate against the US Dollar since 23rd June 2016. The intra-week gains for the Pound stand at around 3%. Looking ahead, we await to see whether Mark Carney shares the hiking-sentiment of the rest of the Committee, the Federal Reserve Bank’s Rate Decision and the result of the German general election.


Tuesday began the Pound’s rally, when Sterling jumped by around 0.5% within most currency pairs. The leap was caused by above-expectation and strongly above-target inflation statistics, as measured by the Consumer Price Index, released by the ONS. Despite representing a weakness of the currency in terms of the purchasing power of goods, the currency gained strength as markets priced in a higher probability of an interest rate hike.


Sterling was raised higher against both the Dollar and the Euro following the publication of minutes from the Bank of England’s Monetary Policy Committee on Thursday. Whilst these minutes confirmed a relative consensus against a rate-hike, they did also signal the willingness of the Committee to raise interest rates in the near future should current trends persist. This message was then confirmed by Committee member, Gertjan Vlieghe, in a hawkish conclusion that rallied the Pound.


Similar upside risk will manifest itself on Monday afternoon of next week when the Bank’s Governor, Mark Carney, speaks at the International Monetary Fund. Should Carney confirm, or even accelerate, the Committee’s intention to raise interest rates in the near future, then Sterling should gain an even firmer stronghold. However, the corollary is also true, should Carney establish a more Dovish tone, the expectation-induced currency gains may be eliminated and even reversed.


Perhaps more importantly, Wednesday will see the Federal Reserve Board decide upon interest rate targets within the United States. Whilst a tightening of monetary policy through the avenue of interest rates seems highly unlikely, a plan for curtailing the asset purchase program, quantitative easing, could well be forecasted. Therefore, considerable upside risk may similarly exist within the Dollar, providing the potential to arrest its year-to-date slide within major currency pairs. Clarifications of the Board’s monetary policy positioning should be availed through numerous conferences and speeches by Members.


Not wanting to be left out, Mario Draghi will also speak in Frankfurt. The ECB President’s last two speeches at the Nobel Laureate Meeting, Lindau, and then Federal Reserve Bank, Jackson Hole, have secured strong and lasting gains for the Euro. We will therefore await to see whether the content and normative message within Draghi’s speech can solidify this trend and send the Euro back to its monthly highs.


Perhaps most importantly of all, Germany will hold its general election on Sunday. The resulting Chancellor, decided within the second vote on the ballot, will be critical in determining the path of European integration and Eurozone completion. The political economy of Europe, given Macron’s presidency in France, could paint an optimistic picture for virtuous integration. Therefore, towards the end of the week, all eyes will be turned towards the German election.



Vlieghe Boosts Sterling’s Gains

Discussion and Analysis by Charles Porter:


Gertjan Vlieghe, an External member of the Monetary Policy Committee, gave a speech in London today offering an uncharacteristically hawkish conclusion. Whilst the conclusion appeared to be only as aligned to a rate hike as yesterday’s Monetary Policy Decision, the endorsement from a characteristically dovish member, and the indication of Committee-consensus, offered financial markets confidence in a hike. Therefore, Sterling experienced a strong appreciation against most currencies taking it to its highest rate against the dollar since the UK’s EU referendum vote.


Delivering a speech to the Society of Business Economists’ at their annual conference in London, Gertjan Vlieghe provided an academic and theoretical discussion of real interest rates and risk. However, at the concluding end of the member’s speech, the useful yet market-neutral content resided in favour of a more practical and market orientated forecast. The anticipated central bank actions that the speech attested to very much followed yesterday’s monetary policy committee minutes publication.


Specifically, this speech at the London conference uncovered Vlieghe’s willingness for “a rise in Bank Rate… as early as in the coming months”. In comparison, these comments conform well to the minutes’ market admonition that the probability of a rate-hike is under-priced and it is thus likely to come sooner than expected. Despite the hawkish closing line within the speech and the published minutes of the Committee, there pervaded a strong conditionality.


Vlieghe’s conclusion was consequential to the satisfaction of four criterions:


“If these data trends of reducing slack, rising pay pressure, strengthening household spending and robust global growth continue, the appropriate time for a rise in Bank Rate might be as early as in the coming months.”


Whilst Wednesday’s publication of employment and wage growth showed a positive and confident economy, the publication also showed below expectation and, crucially, below-inflation wage growth. Therefore, we must question the achievability of at least one of the above criteria and, if we are realistic; more. Despite confident addresses from central bank chairs and heads of government across the globe that the worldwide recovery is maturing, the momentum behind any correction could easily dwindle.


The Euro made considerable gains too against the Dollar on the back of low retail figures. Forecast to rise yet, in reality, falling in percentage change terms, the US Dollar has experienced a headwind today. The last twenty-four hours have seen tragic and serious events including the launch of a second missile over Japanese territory from the North Korean regime. Similarly, geopolitical risk and tension has boiled over into a visible spectrum manifesting as an improvised explosive devise being detonated on a London underground train.


Despite these awful events, a risk-off strategy has not gripped markets strongly, with the trading value of the Japanese Yen versus, for example, the Dollar being low and the price of Gold not evidencing a turn to safe-haven assets. We find ourselves, therefore, in a relatively unpredictable market environment.

Hawkish Message Concealed within Dovish Decision

Discussion and Analysis by Charles Porter:


This afternoon, the Bank of England’s Monetary Policy Committee published what at first sight appeared to be a Dovish decision. However, concealed amidst the interest rate and quantitative easing headlines were more Hawkish undertones. The market, to a significant extent, internalised these comments as a signal of an imminent, before-year-end, monetary policy tightening.


Inflation statistics released on Monday began to entice market sentiment in favour of a rate hike. However, at midday, the headline interest rate, the Bank Rate, was held at 0.25%. Accommodative monetary policy in the form of quantitative easing was also retained at £435bn. However, an actual rate hike was probably never a credible reality this time around. On the back of high inflation, the pound revalued strongly earlier this week despite the lack of hiking sentiment. Therefore, markets may reasonably have been anticipating a turn towards a future rate hike, rather than an actual stimulus reduction. In fact, if we regard futures markets, a divisive probability of a future hike sided with no immediate hike.


What would traditionally represent an accelerating probability of a rate hike in the future is a swing in the vote towards a hike. Because the Monetary Policy Committee comprises of nine members and the previous decision saw only two members vote in favour of a rate-hike, a division in excess of 7-2 would satisfy the expectations that markets priced in over the previous two days. However, Michael Saunders and Ian McCafferty remained the only two members of the Committee to vote in favour of a hike. This was in line with our expectations.


Alone, therefore, the composition of the decision and the lack of movement itself would have forced a selling off of Sterling because expectations were underwhelmed. The empirical reality of the event at midday today, however, was a strengthening of sterling across all major currencies. The driver of this move was a set of idiosyncratic comments contained within the minutes from the Committee’s meetings.


These minutes detailed two currency-appreciating statements. Perhaps the most significant of these two observations was the admonition that if inflation continues to surpass forecasts (as Monday’s announcement attested to) then “monetary policy could need to be tightened” sooner “than current market expectations”. This signals to all markets alike that they have undervalued the probability of UK monetary policy tightening, inducing a flow of capital into the Pound and thus an appreciation.


This movement was reinforced by a second, previous, statement within the Committee’s minutes. The conditional feature of the Committee’s admonition, cited above, was, if current above-forecast trends persist. The second statement lends support to this conditionality. Specifically, the minutes confessed that the Bank of England expects October’s CPI inflation figure to exceed 3%; a critical and exaggerated figure within the British Political Economy. The mandate of the Bank demands that if inflation, the central concern of monetary policy, moves more than 1 percentage point from the targeted 2%, the Bank must explain itself via letter to the Chancellor of the Exchequer.


Therefore, the verification of an antecedent to tightening and a normatively important price level movement install confidence within financial markets that future stimulus curtailment is a reality. The immediate aftermath of the Bank’s publications showed a strong appreciation of the Pound Sterling. Whilst the revaluation against the Euro was stronger than with respect to the Dollar, both immediate shifts were in excess of 1 percent. Gains continued throughout the afternoon, improving the position of individuals selling Sterling.