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European Semantics

Discussion and Analysis by Charles Porter:

 

Tumult within the UK Cabinet developed with the overnight resignation of Secretary of State, Priti Patel. UK political uncertainty, outside of Brexit, has not, thus far, been reflected within Sterling markets. At market open this morning, the Pound appears moderately stronger, ameliorating some of the losses that yesterday’s bearish trend produced. However, with negotiations ahead, this is uncertain to hold. Overnight, the Reserve Bank of New Zealand only acknowledged strengthening global economic growth, joining a string a central banks that only foresee global, not domestic, prosperity. NZ Dollar traded 0.4% down.

 

 

 

Sterling Briefing: Negotiations Begin

 

The first round of Brexit negotiations since European Council President, Donald Tusk, announced a consensus to begin internal preparatory discussions begins today. Given that the European Council is now aspiring to second phase talks next month, there is likely to be cautious optimism priced into the Pound. The fulfilment of expectations will be imperative if Sterling is to retain its present value and begin to gain ground.

 

Brexit is likely to dominate both the short and the long run: the absolute trading band of the Pound is largely determined by the post-Brexit paradigm; short run trends will be determined by the success of this round. Elsewhere within the domestic political economy, Theresa May’s cabinet faces uncertain times following the resignation of both her Defence Secretary and International Development Secretary. For now, this not-so strong and stable government has not manifested into Sterling weakness.

 

 

 

European Semantics: 

 

Brexit as a phenomena may not be being priced correctly. A view that I have analysed is the ideocracy of perceiving Brexit as a zero-sum game; what one party ‘gains’ from negotiations is not taken away from the other. Either way, what is clear is that Brexit negotiations will have impacts for the Euro as well as the Pound. If Brexit is still being (incorrectly) priced as a zero-sum game at this stage, then the retention of bargaining chips is likely to be what awards the Euro with Strength.

 

While investors and the public alike squabble over the semantics coming from chief negotiator Michel Barnier and Secretary of State David Davis, investors will also look to the words of ECB policymakers. In light of prevalent rumors that the ECB members are far more hawkish than President Draghi suggests the views of policy makers will be particularly important. Any suggestion of a defection from the incumbent spate of dovish European monetary policy will be reflected in Euro strength.

 

 

 

Consolidation:

 

The US Dollar has gained considerable ground over the past couple of months. Shown in the adjacent graph, the US Dollar has gained almost 4% against the Euro. What goes up must come down; well, not strictly true with financial markets, however, the commitment to Dollar strength will be tested by investors in the near future.

 

There is scope within the Euro-Dollar cross for the trend to go either way, however, more volatile price action could well prevail.

 

 

 

 

The Days Ahead: 

 

Brexit negotiations will continue to dominate the FX scene, particularly for the Pound. As this continues into the week, markets will remain poised to revalue Sterling. This afternoon, US labour market data will provide clarification to the economy underlying the strong Dollar. This evening, the Banco de Mexico will decide its overnight rate, providing risk to the Mexican Peso.

 

 

 

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Sterling’s Streak Over

Discussion and Analysis by Charles Porter:

Consecutive days of gains for the Pound Sterling have been mildly reversed this morning. Trading slightly stronger overnight, the Pound has almost entirely eliminated the gains it made against the US dollar and the Euro at market open this morning. In the medium term horizon, the Pound has suffered most from a dovish Bank of England Decision. Meanwhile, the long term uncertainty surrounding Brexit underlies the absolute trading channel of the Pound—a phenomena we look towards tomorrow as Brexit negotiations continue. The Euro has appreciated from the lows of yesterday’s market open by almost 0.5%.

 

 

 

Sterling Briefing: Streak Over

 

The Pound has opened lower across the board, stunting the almost week-long gains that we have witnessed. While the market could simply be testing new ground following the emergence of a new monetary paradigm within the UK, it remains plausible that Sterling’s weakening is in fear of yet another underwhelming Brexit negotiation round.

 

Sterling markets are not hoping for miracles at any moment from the Brexit negotiations. Instead, something as simple as the linguistic tone, or even body language, between Brexit Secretary David Davis and the EU Chief negotiator, Michel Barnier, could be enough to prop-up the Pound. With the Financial Times this morning headlining the threat of mass-business exodus from the UK, there is considerable pessimism heading into this round of negotiations.

 

 

 

Euro Briefing: European Recovery

 

The Euro proved resilient against the US Dollar again yesterday afternoon, capping the interim peak in Dollar strength that has prevailed since last week’s European Central Bank monetary policy decision. The comeback seen yesterday afternoon has continued this morning, providing support to the hypothesis that the Euro’s decline against the Dollar was overdone.

 

We witnessed a brief acceleration to the Euro’s recovery yesterday as reports abounded that the ECB may not be as perverse to tighter monetary policy—as dovish—as Draghi makes the Bank appear. The report suggested that there was dissatisfaction and quasi-defection within the Governing Council with more hawkish members attempting to alter the path of European monetary policy.

 

 

 

Dollar Briefing: Risk Off

 

While the main major loser at market open this morning appears to be the Pound Sterling, there was also a considerable weakening of the trading value of the US Dollar. As President Trump arrives in China having left South Korea, markets are bracing for a more volatile series of press conferences and sound bites that will increase the already-magnificent political risk surrounding the United States.

 

During Trump’s election campaign and throughout the infancy of his Presidency, the relationship between the US and China, a globally significant trading channel, has been tumultuous. Moreover, as the crisis within the Korean Peninsula has matured, the relationship between China, including President Xi Jinping, and North Korea, including the supreme leader Kim Jong-un, has made for disturbing headlines. Trump’s aggressive foreign policy is therefore cowering Dollar markets a little lower.

 

 

 

The Days Ahead:

 

Today, the Reserve Bank of New Zealand will release their monetary policy decision detailing the Official Cash Rate. With an insignificant risk of a rate hike priced into New Zealand’s debt and currency markets, sentiment is certainly on the side of a no-hike. However, as the Bank of Canada proved a couple of months ago, central banks can always surprise us. Globally, geopolitical risk including, but not limited to, the acceleration of Saudi Arabian political tension, Brexit, and Trump’s tour will dominate the foreign exchange environment.

 

 

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Political Risk in the Rand

Discussion and Analysis by Charles Porter:

 

On the Wednesday 25th October, the South African Rand sustained an intraday loss well in excess of 3%. The devaluation was caused by the pessimistic, yet honest, budget speech from South African Finance Minister, Malusi Gigaba. Against the Pound Sterling, the effect was tempered briefly by a bout of Sterling weakness following the Bank of England’s decision to raise interest rates by 25 basis points. Following the losses at the end of October, the Rand appears to have embedded itself within a new trading range, appearing temporarily incapable of eschewing the risk that now surrounds its underlying economy.

 

Speaking in Cape Town, the Finance Minister painted an extremely gloomy picture of the South African economy during his first Medium-term Budget Policy Statement. The speech included, although was not limited to, the significant concerns over public debt, ramifications to the capital and current account deficits, and a low propensity for future South African economic growth. Ultimately, the concerns surrounded the indebtedness of the economy.

 

Taken as a whole, the elements of Malusi Gigaba’s speech were mutually reinforcing. Foreboding a significant expansion of the market supply of government bonds and treasuries, the creditworthiness and solvency of the economy was brought into question. Currently enjoying the status of investment-grade debt, the speech’s admonitions made investors seriously question whether the credit rating agencies’ classification was correct and thus likely to change in the future.

 

Having just emerged from a recession, economic growth is forecast to slow, potentially threatening negative territory once again. The headline concern was a projected shortfall in government taxation revenues, amounting to several hundred billion Rand. Deriving from this shortfall in revenue, the budget deficit is forecast to accelerate considerably. Projected to exceed 60% of GDP within a five-year horizon, alongside an inflated implied debt servicing cost, the credibility of South Africa’s fiscal profile was eroded.

 

Sixty percent of GDP remains a respectable threshold of public debt. Academic and professional studies have conjectured at levels closer to 100% of GDP before an inhibition to growth will arise. Moreover, within the Eurozone, for example, the Stability and Growth Pack explicitly chooses 60% as a threshold level, building the figure into its debt sustainability formula. However, these projections are largely assumed to be adequate within highly developed counties with an outstanding ability to raise debt.

 

In less developed markets, when refinancing costs are high and government bonds attract higher yields, the cost of maintaining such a level of debt becomes unsustainable. However, with outstanding growth, the capacity to service and raise debt is once again unencumbered. However, because the report simultaneously slashed economic growth forecasts, the possibility of offsetting higher debt with stronger growth is foregone, much to the detriment of the Rand.

 

Most of the deterioration of the Rand was related to uncertainty and the pricing in of risk. The investment grade status of South African treasuries is imperative to the sustainability and economic growth of the economy. Fitch Ratings, Standard & Poor’s and Moody’s are all poised to downgrade South African government bonds at any time should they perceive the political and institutional risk, or the domestic economy, as unworthy of investment.

 

Following the surprise dismissal of respected minister Jacob Zuma earlier this year, Malusi Gigaba took up the cabinet position. The political fallout from the event was considerable, generating particular volatility within the Rand. The appointment of a new minister of finance, as Fitch Ratings and Standard & Poor’s agencies immediately understood, generates the propensity for a change in policy direction. Therefore, at some level, the deterioration of the Rand can be viewed as an extenuation of an underlying political uncertainty.

 

Ultimately, a ratings downgrade is equivalent to an increase in the probability of a default upon extant and new debt. The significance of the ramifications alluded to within Gigaba’s speech provide a good understanding of the future risk within the Rand. Should the credit ratings agencies downgrade South African government bonds through the ‘trash’ status then the Rand will suffer considerably. Following the event, the Rand has failed to recover any significant value back. Therefore, the risk of this event is still strongly priced into the currency, and its debt markets. Forthcoming economic data will unveil whether the fears contained within the Minister’s speech are accurately priced and thus, determine the future path of the Rand.

 

 

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European Bear

Discussion and Analysis by Charles Porter:

 

Following the modest gains that Sterling made throughout yesterday afternoon, on the whole, Sterling opens mildly stronger. The biggest mover overnight was the US Dollar. In particular, the Dollar has gained ground against the Euro, with the EURUSD currency pair currently trading at its lowest level in over three months. Elsewhere, the RBA chose to keep interest rates on hold, citing ’uncertainties’. The language of the decision at 03:30 BST briefly strengthened the Aussie Dollar, however, the gains were short-lived.

 

Sterling Briefing: Recovery

 

Following the shock devaluation of the Pound on Thursday of last week, Sterling has gained back considerable ground. Posting consecutive intraday gains for the last three days, a considerable proportion of the devaluation generated by the Bank of England’s Monetary Policy Decision has been reversed.

With sparse data and events planned for the beginning of this week, there are few anticipated phenomena that contain the propensity to move the Pound considerably. With production data out on Friday and, in particular, Brexit negotiations commencing on Thursday, news from home and abroad may unsettle the stability of Sterling.

 

 

Euro Briefing: European Bear

 

 

The shock devaluation of the Euro caused by a ’dovish’ tapering of Eurozone quantitative easing was in excess of 1.5%. Following this event, the Euro appears to have entered into a bear market – consistently losing ground against other currencies. These trends appear to be a market correction back from the bout of considerable Euro strength that we saw at the start of September.

Given the short term bullish market we are witnessing in the Pound, this episode improves the bargain of those selling Sterling and buying Euros. Moreover, with Mario Draghi, President of the ECB, speaking publicly this morning, Euro markets could prove sensitive as they strive to price in the path of European monetary policy.

 

 

 

Dollar Briefing: Asia Tour

 

 

Following the Japan leg of Trump’s tour of Asia, President Trump has arrived in the South Korean capital of Seoul. There will inevitably be a plethora of press conferences and opportunities to hear from the US President. The sound bites from these events always contain the propensity to move markets, particularly when the salient issue of US defense policy is on the table. For now, there looks to be little recoil or encouragement within the Dollar derived from any of Trump’s comments, however, we will wait to see if this trend holds.

Regarding the US again, Randal Quarles, vice chairman of financial supervision at the Federal Reserve, will be speaking. This is his first speech in the role and, therefore, there will be a considered attempt to price in his potential influence within the Fed.

 

 

 

The Days Ahead:

 

The Reserve Bank of New Zealand will unveil its latest monetary policy decision on Wednesday evening, UK time. With the present rate of 1.75% having been held since the start of the year, and inflation looking more healthy, it is not implausible for the Bank to raise the Official Cash Rate. The previous monetary policy statement revealed that the Reserve would not be averse to raising the target rate soon, releasing risky upside potential into the New Zealand Dollar.

The absolute trading levels of the Pound Sterling, when considered over the long-term, are primarily down to Brexit uncertainty. Therefore, any event that has a reasonable chance to clarify the future status of the UK vis-à-vis the world and Europe will provide support to the Pound (provided it is not disastrous news!). The market importance of Brexit negotiations and politics is therefore hard to overstate.

 

 

 

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Weekly Briefing

Discussion and Analysis by Charles Porter:

 

Sterling opened approximately in line with Friday’s close of play but has appreciated throughout the morning so far. Over the weekend, rumours have been debated as to the key element’s of Chancellor Hammond’s forthcoming UK Budget speech. Although a while off, markets will jostle to price in the extent of UK borrowing. The day ahead looks to hold particular risk within the Aussie Dollar, with the Reserve Bank due to meet early tomorrow morning UK time. However, as Brexit talks continue to determine Sterling’s value, we look ahead to the next round of negotiations commencing on Thursday.

 

 

Sterling Briefing: Technocracy to Politics:

 

Opening approximately in line with the value recorded on Friday, Sterling markets are largely unchanged after the weekend. Last week and, in fact, those that preceded it, was dominated by the actions, or anticipated actions, of the Bank of England, the UK’s technocratic and apolitical body responsible for setting interest rates.

 

In contrast, this week will be characterised by the actions of the UK government and its democratic politics. With markets beginning to speculate and price-in Chancellor Hammond’s forthcoming Autumn Budget, and as Brexit negotiations strive to reach ‘sufficient’ progress, the Pound contains both potential and risk.

 

 

Euro Briefing: New Equilibrium:

 

The Euro still trades down against the US Dollar when compared with the enduring levels seen last month. The sell-off from the Euro following Draghi’s dovish taper looks to have stuck with a level of political risk inconsistent with immense short-term appreciation.

 

Today, there will be a limited significance to Eurozone ‘soft’ data. The release of PMI data, concerning confidence within the Euro area’s underlying economies, is a final estimate of data previously released. As such, there is lower risk associated with its release.

 

 

Trump’s Tax Plan:

 

Anticipation of the tax plan has provided a support to the US Dollar as far back as when the currency president had been elected. The anticipated breaks to business and commerce were received positively by the US Dollar and, as such, markets began to price fiscal progress into the currency right from the beginning.

 

Despite markets questioning the value of a Trump, Republican, Presidency along the way, they do not appear to have been overly disappointed with the materialisation of the plan. For now then, US Dollar market attention should turn to the facilitation of the plan that continues in Congress today.

 

 

The Days Ahead:

 

The Reserve Bank of Australia will be meeting in the early hours of tomorrow morning to set monetary policy. With interest rate policy stagnating in Australia, with a no-hike for 13 consecutive meetings, the confidence effect of a policy change and upward revision of interest rates would endow the Aussie Dollar with considerable strength. The probability for this looks limited, however, a change to the language and sentiment of the Bank would achieve comparable progress.

 

Trump’s visit to Asia will contain valuable sound-bites that can easily affect the value of the US Dollar. Similarly within the US, the progression of the Tax plan will not be a one-off event; progress as well as hindrance could appear at virtually any point along its constitutional path. In the UK, tumultuous Brexit negotiations have expectations to fulfil, with second round facilitation expected by December. The extent to which this possibility is priced into the market will determine the fall out from a validation or denial of the conjecture.

 

 

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Saudi Instability

Discussion and Analysis by Charles Porter:

Political and geopolitical risk has been amplified immensely this weekend. The threat to the kingdom of Saudi Arabia is significant, particularly given the nation’s exposure to crude oil. The threat escalated when a ballistic missile was reportedly fired from Saudi Arabia’s southern neighbour, Yemen, towards the kingdom’s capital. The threat was intercepted, however, has led to significant tension within the Middle East. At first sight, the foreign exchange story to this development is somewhat bland; Saudi Arabia has a currency that is pegged to the US Dollar. However, the geopolitical and political spill-overs from the conflict could manifest into a larger story.

 

The Saudi Riyal maintained its value of approximately 3.75 riyals to the US Dollar. Despite not being explicitly pegged against currencies other than the Dollar, arbitrage will ensure that an approximate parity with other currencies applies. Therefore, despite a highly tumultuous political and geopolitical backdrop, the value of the currency, even on a trade weighted basis, barely falters. What is interesting is that the support of a pegged exchange rate will require significant action as pressures increase to devalue to Riyal.

 

With an exporting value of crude petroleum considerably over 100bn US Dollars, the significance of Saudi Arabia to the global political economy is immense. Moreover, the negative correlation between the US Dollar, arguably the world’s most significant reserve currency, and the price of oil is highly non-negligible. Whilst the causality is normally presumed and justified as running from the US Dollar to crude oil, there is a high probability of feedback in the US Dollar due to uncertainty within oil prices.

 

The price of crude oil is expected to spike significantly when the market opens later today. Due to the significance of oil to the modern, advanced, economy there could be significant implications upon international trade, inflation and disposable income, to name but a few. Clearly, the spill over to the real international economy will provide idiosyncratic national pressures that will include, but not be limited to, the highly market-sensitive instrument of monetary policy.

 

Due to the exposure of the US Dollar to the crude oil market, it is likely that the US Dollar will face new pressures should an inflated price of oil manifest and become sustained. The consolidation of the market for oil within US Dollars means that if the price of oil rises, the demand for US Dollars should increase. This relationship holds because the demand for oil is relatively price inelastic – the dependency of the western world to oil through the lack of a viable substitute and impressibility of curtailing production means that, despite any rise in price, the amount of oil demanded is relatively constant.

 

When the price of oil rises due to investors’ and consumers’ fears, the total value of oil traded within the time period will rise. Whilst the market for oil is denominated and traded within US Dollars, participants in the market are not necessarily, and in reality frequently are not, liquid or denominated in US Dollars.

 

Therefore, when participants engage with the crude oil market, they are frequently required to sell off considerable funds in their liquid base currency and purchase US Dollars. Upon this exchange, the demand for US Dollars necessarily increases, raising the market clearing price of the Dollar. Therefore, price pressures could well manifest within US Dollar markets.

 

Elsewhere, instability within the world market could perceptibly cause a risk off strategy, benefiting currencies including, but not limited to, the Japanese Yen and the Swiss Franc, at the expense of the Dollar and the Euro in particular.

 

Historic Rate Hike

Discussion and Analysis by Charles Porter:

The Bank of England’s Bank Rate has been raised by 25 basis points. Strangely, the rate hike forced the Pound Sterling downward. The counter intuitive foreign exchange movements following the Bank’s decision are explained by a combination of the overpricing of a rate hike and a ‘dovish’ tightening. Whilst the first rate hike from a central bank in 10 years might rightly suggest an unmistakably hawkish monetary policy move, the forward guidance undermined a rising cost of borrowing. Upon the news, the Pound Sterling lost an indicative 1% against the US Dollar.

 

The monetary policy decision was accompanied by an inflation report for the UK economy. The report and press conference indicated inflation expectations within the UK are only likely to return to target within the next two years. Despite excess inflation, the monetary policy decision was accompanied by forward guidance indicating only one rate hike a year for the next two years. This Brexit-led interest rate policy generated impressions that the rather hawkish decision of the Bank of England to raise the rate of borrowing was in fact a dovish event.

 

The concomitant decline in the value of the Pound Sterling was starkly negative. Following the announcement and the press conference, markets repriced the probability of a rate hike in the future. Extending the curve forward, markets are unable to price an interest rate hike to much over 2% even in the ultra-long-run.

 

Carney proved the credibility of the Bank by sticking to its forward guidance and, as such, proved himself to be less of the unreliable boyfriend. However, Carney also drew criticism from a wide range of market commentators for a premature and ill-considered monetary policy decision. To understand the fall out within the currency market it is important to understand the complexion of the decision itself.

 

At face value, a 7-to-2 division within the Monetary Policy Committee (MPC) is a highly confident vote for an interest rate hike. The only two members of the MPC that did not vote in favour of the rate hike are renowned for their dovish attitude towards monetary policy. Whilst the longer standing member, Jon Cunliffe, has a proven voting history and attitude towards lower rates of borrowing, David Ramsden’s persuasion towards the preservation of accommodative monetary policy has only just become apparent.

 

Taken at face value, a central bank confidently hiking rates for the first time in a decade would tend to appreciate the exchange rate dramatically. Moreover, an inflation rate that is predicted to stay above three percent at least until the end of the year would similarly persuade markets that a further interest rate hike was either imminent or, at least, far from a one-off manoeuvre.

 

The problem with this impression, and the reason that Sterling faced a counter intuitive depreciation was the source of inflation and the capacity for the real economy to internalise a higher rate of borrowing. The source of inflation comes entirely from abroad, with the deterioration of the exchange rate following the Brexit referendum being the reason for inflated importation prices. The proof for this opinion is the low inflationary pressure that the domestic, inwardly-orientated, service economy is producing.

 

Therefore, because inflation is ultimately a statistic that measures year-on-year change, eventually the current high price level caused by a persistently low-valued Pound will be compared within a similar state of affairs; the incumbent paradigm of a post-Brexit United Kingdom. This understanding explains the dovish decision from the Bank of England MPC. Their report must not over stimulate British markets that price a higher return to investment and saving when there remains the possibility that before the final secession of the UK, there is under-target inflation within the UK economy.

 

 

Fed on track to hike rates in December

Discussion and Analysis by Charles Porter:

 

Yesterday evening, at 18:00 BST, the Federal Open Market Committee (FOMC) of the Federal Reserve System published its latest monetary policy decision. The minutes released alongside the decision detail that there will be no November rate hike within the US, however, the economic outlook remains positive. Whilst the Chair of the Federal Reserve Board looks to be reallocated, supposedly within the day, markets turn to understanding the path of future monetary policy within the US.

 

The minutes released by the FOMC were largely unchanged from their previous form. The take away message was overwhelmingly similar: there’s still no inflation, but the economy looks good. Markets are having an easier time with the US central bank than many others across the global political economy. The path of interest rates has been transparent, although, at times, incredible given the dominant economic forecasts suggesting that the US economy could not contain a higher rate of borrowing.

 

With the probability of a no-hike priced into financial markets around the 98% mark going into yesterday evening, it is unsurprising that the US Dollar was relatively stable around the release. Due to the forward guidance primarily expounded by incumbent Fed Chairwoman, Janet Yellen, that there will be one more hike in 2017, markets have almost completely priced in a hike during the December meeting.

 

Due to this forward guidance and the Fed’s market steering, the content of the minutes itself were all that really held the propensity to move markets. The minutes remained on a steady course, arguably with a slight appreciation of the economic outlook. The Board still expressed the health of the economy, only this time had far more positive economic observations to back its claim up. Economic growth as measured by Gross Domestic Product, for example, has stayed above the 3% mark for two consecutive quarters. With soft data similarly developing confidence levels in the US economy, the minutes did not disrupt dominant market expectations in the slightest – hence minimal foreign exchange movements.

 

Whether Trump, in an announcement thought to be scheduled for this afternoon, picks Jerome Powell or John Taylor to replace Yellen looks to be the next major market-moving US Dollar event. The appointment of the super-hawk that is John Taylor would considerably strengthen the US Dollar. Whilst Powell looks arguably more hawkish than the incumbent, Janet Yellen, his appointment is unlikely to change the composition of the overall FOMC dramatically. The extent to which each candidate is already priced into the market will determine the fall out from Trump’s announcement.

 

The interest rate target was set, once again, at 1.00-1.25%. When getting overwhelmed by incremental 25 basis point rate hikes, it is easy to overlook the abnormality of a cost of borrowing little over 1.00%. With monetary policy still at ultra-low crisis levels, a normalisation should be welcomed. Particularly within the United States, all that seems left of the jigsaw puzzle is inflation.

 

Employment, economic growth and confidence are all at strong, normal time, levels. With economies threatening their natural rate of unemployment, or NAIRU, it is a surprise that wage inflation and thus general inflation has not accelerated. This hinderance is no secret of central bankers. From this stance, understanding the propensity for non-exchange-rate led inflation following structural reform in the wake of financial and sovereign crises, could be the key to understanding dominant exchange rate trends.

 

UK Market Confidence Grows

Discussion and Analysis by Charles Porter:

 

This morning, at 09:30 BST, IHS Markit released its Manufacturing Purchasing Managers’ Index. The data approximates managerial sentiment within the manufacturing industry and is thereby used as a proxy to understand the domestic macroeconomy. The latest release of this fast-moving index demonstrated a tick up in economic sentiment and confidence. Ahead of the Bank of England monetary policy decision, due tomorrow, the data led to an appreciation of the Pound Sterling of approximately 0.2%.

 

The purchasing managers’ index (PMI) is known as ‘soft’ data. This means that the underlying data, based upon survey responses, does not represent a tangible, value based, indicator of the economy. Instead, soft data measures sentiment and confidence. Concerning the manufacturing sector, this morning’s release shows the flash estimate of purchasing managers in October.

 

Positively, this makes soft data indices, such as the PMI, far more reactive to short term trends, allowing them to pick up on economic trends in a far more timely manner than traditional hard data. Negatively, the volatility of these indices and the normative, judgement, basis upon which they are formed means that their reliability should occasionally be questioned. Therefore, when the monthly change is negligible, the absolute value of the index publication should be qualified. The negative aspects of the soft PMI data are partially qualified by the extensive base of purchasing managers.

 

Today’s release was not magnificent when considered in terms of a month-on-month change. The revised data only moved up to 56.3, up 0.3 points from a previous 56.0. What is more important, and what moved currency markets, is the reversal of incumbent market expectations. The consensus forecast was for a moderate turn down of the managers’ index, with many market participants foreseeing a considerable decline in market sentiment.

 

An appreciation of the Pound Sterling following the release of IHS Markit’s index was therefore built upon the reversal of market expectation. Being an indicator of market sentiment, PMI expectations are likely to be a reflection of investors’ perception of market conditions. Therefore, it is likely that over the month of October, investors had internalised the more pessimistic market sentiment within the Pound Sterling transactions.

 

The release of PMI data that falsifies investors’ preconceptions about the UK manufacturing market creates the opportunity to price in UK manufacturing market sentiment. From the release, UK sterling markets gained just short of 0.2%, visible within the graph below.

 

 

The movement within Sterling-Dollar and Sterling-Euro currency crosses was diminished by the size of the manufacturing sector within the UK. With manufacturing accounting for less than 20% of the UK economy, according to calculations based upon Office of National Statistics data, the services sector dominates both trade and the domestic economy.

 

For an economy with low dependency upon the manufacturing industry, it is unsurprising that the currency market movements following the statistics release were not more magnificent. However, ahead of the Bank of England monetary policy decision due tomorrow at midday, confidence within the manufacturing sector will lend support to the initiative of a rate hike.

 

With a higher rate almost completely priced into UK Sterling markets and the Bank under increasing pressure not to disappoint market expectations, the PMI data may instead, in practice, facilitate a more hawkish monetary policy announcement. The role of interest rate expectations is a secondary factor influencing the currency market appreciation following the publication. For now, all eyes turn to the Bank of England tomorrow afternoon.

 

Cutting off your nose to spite your face – Brexit

Brexit Discussion and Analysis by Charles Porter:

 

Italian Prosecco, German automobiles and French wine. While bargaining chips are poured out only to be raked off the table, Brexit is coming more convoluted. No deal is better than a bad deal; no matter what you make of that statement, we’re all relatively unified behind the idea that a bad deal, or a no-deal, is inferior to a good deal. Surely the same should be true for the Eurozone, however, markets appear to be unsure about how to deal with this phenomenon.

 

Let’s not forget, after all, Brexit hurt the European Union and the Eurozone too. Undermining the longevity and confidence within the European project, the Brexit vote saw the Euro slide by 3.5% against the US Dollar.

 

Of course, the slide was far less magnificent than the decline of the British Pound. Losing nearly 12% of its purchasing power against the US Dollar, the Pound sank towards long-term lows across the board. The snap loss against the Euro was moderated by the implication of the Europe itself within the phenomenon of Brexit.

 

Despite popular misconception, Brexit is not idiosyncratic to the UK – far from it. The insulation of the trading value of the Pound Sterling-Euro cross was in the order of 30%. Whilst not directly attributable to the relative burden of a Brexit upon both parties, the inextricable relationship of mutual harm or mutual support should be inevitable.

 

In other words, it appears inconceivable that Brexit is a zero-sum game; surely, what one party ‘gains’ through progress and certainty is not a value taken directly from the other party. Admittedly if Brexit is, as I suggest, a positive-sum game then any advancement in negotiations can, and must, still have a larger effect within the UK than Europe. This is because there is more uncertainty priced into Sterling markets.

 

Turning to events following the referendum itself, we see that markets are not pricing Brexit negotiations as a positive-sum game. This is apparent because Brexit related movements within the Euro and Pound have been inverse, even when they ought to be mutual. Despite occasional ridicule of Mr. Johnson, prosecco, wine and cars are negotiating chips because mutual trade is unequivocally important to both sides of the Channel.

 

Progress in first round Brexit negotiations facilitates consideration of the second round concerning the future relationship of the UK and the EU. If the Florence speech was, as European officials have agreed, such a success then the Euro and the Pound ought to have both received a tailwind.

 

The Florence speech contained partial assurances and advancements on citizens’ rights, Northern Ireland, and a sheepish €20+bn guarantee.

 

It seems implausible that these guarantees do not considerably reduce the uncertainty within the Eurozone economy surrounding a no deal. The Prime Minister’s concessions to the European Union prevent funding and budgetary crises in the absence of Macron’s desire towards a budgetary union. Moreover, they weigh against the likelihood of public crises within the European Union that have marred it before (cf. migration crisis).

 

Therefore, the realisation of a bearish Euro and bullish Sterling following episodes of Brexit progress is remarkable. It is understandable that the Sterling-Euro currency pair would be bullish – in favour of the Pound. However, for the Euro to consistently weaken against, for example, the US Dollar and major international currencies, is astounding. Despite implausibility, this is what we saw following PM Theresa May’s Florence speech.

 

The same story is true following the recent and highly progressive EU Council meeting that concluded on 20th October. Donald Tusk, President of the European Council, announced that the Council has “agreed to start internal preparatory discussions” regarding the future relationship. Lending weight once again to the Florence speech, President Tusk praised the speech.

 

Once again, however, Brexit progress was met by considerable and sustained Sterling strength amidst Euro weakness. Cable, the US Dollar-Pound Sterling exchange rate, appreciated throughout the day and into the next week with the very same trends being reflected in the value of the Pound with respect to the Euro. In contrast, the Euro diverges strongly, trending downwards admittedly in a sign of Dollar strength, but also unmistakable Euro weakness.

 

So why?

 

Is the market incorrectly pricing the value of good Brexit news to the Euro? Or is the probability of an immense divorce bill, free trade and European cohesion so heavily priced into the exchange rate that Brexit progress simply doesn’t matter? Or, however unlikely, is no deal genuinely better than any deal for Europe?!

 

Well, it’s hard to say. Certainly, the latter two are not base cases for the Euro. Its strength has been derived from the re-emergence of economic growth and the hope of future inflation. What is certain, is that price action surrounding Brexit events should be watched closely.

 

Ultimately, the European Union is void of a legal binding. Whilst Article 50 seems vague and impenetrable, the clause does provide the Lisbon treaty with the capacity to secede from the Union. Therefore, in order to achieve  acceptable cohesion within Eurozone, which is the principal source of value for the Euro, the benefits of membership must continually remain in excess of its costs.

 

The quantification of costs and benefits within a diverse Union is not simple. However, it certainly spreads across more than pecuniary budgetary contributions and receipts.  With external trade deals proving popular within the Union (c.f. Canada), the future EU-British trading relationship will be important to the trade-off. Therefore, markets should price Brexit progress as mutually positive for the Pound and the Euro.

 

Find more Brexit analysis here.