Trump’s currency war by stealth, and why the pound is in the doldrums
Today’s stock market price action might seem like everyone is on a beach in the Med, however there are some key events happening right now that could determine the direction of financial markets throughout the summer months and beyond.
Brexit mess hits pound, but for how long?
The pound has been the worst performer in the major currencies this week, and GBP fell sharply across on the board on Tuesday as investors priced in a growing risk of a disorderly Brexit. Politics is, once again, biting at the pound, and is having more of an impact on the currency than a spate of better than expected economic data. GBP/USD fell below $1.24 on Tuesday, however, at the time of writing it has managed to claw its way back above this level, after inflation data matched expectations, the headline inflation figure for June was 2%. This is the Bank of England’s target rate, and traders are willing to take this piece of economic data seriously, if inflation remains around target then the BOE, technically, should not cut rates even in the face of a disorderly Brexit later this year.
GBP: spot market vs. options market
There is an interesting dynamic going on in the GBP market at the moment. The spot market is finding it increasingly difficult to digest news about the Brexit process, which is triggering the volatility that we saw on Tuesday. For example, Boris Johnson, still the front runner for the Tory premiership, said on Tuesday that he would ditch the Northern Irish backstop to get the UK out of the EU by the October 31stdeadline. This was perceived as a significant shift towards a “hard Brexit” hence the decline in the pound. These clunky movements in the FX market are likely to become more pronounced once we get a new Prime Minister later this month, and negotiations with the EU restart. The sterling market is definitely in reactionary mode, and that is why it is difficult to take a long-term view on where the currency will go next. On a broad-basis, if you think that GBP/USD is at risk of falling to approx. $1.15 on the back of a no-deal Brexit later this year, and since the current price is approx. $1.24, then the market is pricing in just over a 50% chance of a no-deal Brexit at this stage.
The options market is also worth watching, implied volatility, which tracks expectations of volatility over the next three months, has ticked up in recent days, although it remains below the peaks reached last year when Prime Minister May was first trying to get her Brexit deal through parliament. There is a large amount of hedging activity around the deadline date of 31stOctober, however, overall the options market suggests that investors still think another Brexit extension is likely, especially if there is a General Election either later this year or early in 2020, as Boris Johnson, a candidate to be the new PM, suggests.
Although the options market is fairly stable, especially compared to the steep decline in sterling this week, the pressure for further weakness in the pound continues to build. This includes, the need to fund a large current account deficit, and a potential further reduction in the BOE’s UK growth forecasts that will be released with the August Inflation Report next month. This may increase the chance of a rate cut, which is pound negative in the medium to long term.
Trump’s currency war by stealth
However, whether or not the pound continues its downhill tumble from here, or if it will pause for breath is also dependent on what the dollar does next. The economic data from the US has been strong this week, housing starts, released later today, are expected to pick up. However, politics also plays into the dollar. President Trump has been complaining about the strength of the dollar for years, his most recent target for criticism has been the Federal Reserve for their rate-hiking cycle last year. Now that has been reversed, and the dollar is still rising even though the market is pricing in up to 3 interest rate cuts for the rest of this year, President Trump may need to change track. This week he has reminded the markets that he could add more tariffs to Chinese goods as a way to punish “unfair” Chinese trade practices, however, he may also start to target a wider group of countries if the dollar continues to rise. While the US government is unlikely to directly intervene in the FX market, Trump could start to punish countries with a weak currency by using trade tariffs. Ultimately this could be currency manipulation by stealth, as large exporting countries to the US may feel compelled to let their currencies rise to avoid the wrath of the Trump administration and potential tariffs. While this idea may sound outlandish now, we believe that the risk of a currency war is alive and well, and the EU could be the next target. EUR/USD may not have a long-time left hovering around $1.12.
Earnings season fails to set market alight
Stocks are fairly boring this week, the S&P 500 is desperately trying to hang onto life above 3,000, however, it is losing steam above this level, which suggests that a sell off could be on the cards. So far, earnings season hasn’t set the world on fire. While Citi and Goldman Sachs beat expectations, Wells Fargo and JP Morgan only managed to meet expectations, with Wells falling short of expectations. This suggests that in the current environment, retail banking alongside investment banking are not the cash cows that they once were. Considering the financial sector was expected to be one of the better performers for Q2, this does not bode well for the US corporate sector, which adds to our view that stock markets may not stay in record breaking territory for long, especially if the Fed fails to cut rates by 50 basis points at its meeting later this month. Expectations are now at 30% for a 50 bp cut at the 31stJuly meeting, which could trigger an ugly market reaction if these expectations are not met.