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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.

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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.

 

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.

 

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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.

 

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.