Head of FX Strategy
Summary: Sterling is in free fall as UK Prime Minister Boris Johnson won't talk to EU leaders unless the EU is willing to open of for renegotiating key aspects of May's Brexit deal. The week's main event is tomorrow's FOMC meeting, where the size of the rate cut may matter little beyond the knee-jerk reaction.
Trading interest
Sterling in freefall as UK and EU engage in game of chicken
Sterling has lurched into a freefall as new UK Prime Minister Boris Johnson has made it very clear he is willing to do everything to keep all options on the table – including the “cliff edge Brexit” option – to maintain leverage against the EU, even as he claims confidence in a deal being reached. The latest stand-off has deepened as Johnson refuses to contact any EU leaders until they re-open negotiations. The EU has maintained it is unwilling to do so and that the only deal possible is the extant deal hammered out with former Prime Minister Theresa May.
A study by the UK’s CBI suggests that neither side is truly ready for a No Deal Brexit but that the EU side is even less prepared than the UK. It is difficult to gauge how far the two sides are willing to take this stand-off, but it is clear in the interim that sterling is seen as the escape valve. But I think the euro should be absorbing a bit more of the negative impact than it has thus far, with the 1.1100 level in EURUSD perhaps only surviving thus far. Already before a possible cliff-edge Brexit, the Germany export machine is on its knees, with the manufacturing PMI in the low 40’s there. And the UK is nearly as large as China as a German export destination – nearly 7% of German exports. EU-wide the figure is a staggering £345 billion pounds in exports to the UK. Is the EU really willing to trigger a recession in the EU by punishing one of its largest customers?
A month or so ago, I maintained that some form of realpolitik would eventually prevail that would result in a managed Brexit with a long road of further negotiations for a final trade deal. The market seemed to have priced this outcome to a degree as well, and has become very uncomfortable with the game the two sides are playing at present. Of course, the setup now is that if the EU side gives and opens up for talks, sterling could rally 2% or more in a heartbeat, so some further slow accumulation of longer term optionality in sterling upside versus the single currency has become more compelling in the event a race toward a cliff edge is avoided. That’s not to say we don’t test 0.9300 or higher in EURGBP first – quite possible the longer the standoff continues.
Chart: GBPUSD
Cable is now trading below its lowest weekly close since 1985, which was in early 2017 at around 1.2165, but the obvious psychological testing ground here is likely the round 1.2000 area. As we discuss above, the headline risk is extreme for sterling now, and likely beginning to skew to the upside rather than the downside for sterling at these levels – at least in terms of short-term headline reaction function. A sterling positive headline would be one of the sides yielding in its stance – and given Boris Johnson’s staking everything on delivering Brexit by hook or by crook, it would have to be an announcement from the EU side agreeing to renegotiate the deal for any hope of stabilization or better for sterling in the near term.
FOMC preview: Fed cutting has nothing to do with dual mandate?
It’s easy to scratch our heads and wonder why the Fed feels the need to start an easing cycle when asset markets are trading at record highs and the unemployment rate is near record lows. The Fed has ginned up the weak “symmetric inflation” argument to explain its motivations (the need to move inflation above the 2% target for some time to compensate for periods in which inflation was below that target). But the true source of the Fed’s moving to cut is that is has already largely lost control of policy. The lack of dollar liquidity provides its own dynamic and has been aggravated by Trump’s massive tax cuts and stimulus requiring the US private sector to soak up vast quantities of treasuries now that foreign buyers are no longer adding to reserve holdings. Another immediate factor is the debt ceiling suspension from the deal Trump made with Congress, which will now see the US Treasury building its reserves again to the tune of hundreds of billions of USD.
As well, other central banks are already winning the race in a competitive devaluation game (“currency war”). And the fact in and of itself that the massive shift in the Fed’s policy outlook has failed to weaken the USD is providing its own motivation and forcing the Fed’s hand. Shortly put, everyone wants to know whether the Fed will cut 25 basis points or 50 basis points tomorrow, but I am not sure that it matters beyond the initial knee-jerk. To get ahead of the USD liquidity issues, the Fed will have to soon start QE and massively so – rate cuts area a mere distraction.
Worst, the trading environment will likely prove tricky. We have made a long term weaker USD call in our Q3 outlook – but if the Fed proves too slow here, we could just see another spike higher first. That spike in turn will drive the next Fed policy move and so on, ad infinitum. And the Tweeter in Chief at some level in the USD will also be happy to break precedence (and recent direct denials) and empower the US Treasury to intervene in the market, although the first move may be via trade policy bullying.
This environment will require nimble trading and the use of options. And outside of sterling – volatilities look like a bargain for going against the grain and beginning to establish longer term USD shorts versus the JPY and EUR if the USD breaks higher here, even if trading tactically for short term USD strength.
What else is up this week?
The FOMC meeting tomorrow is clearly the main event this week for all markets, but we also have the US June PCE inflation data up today, expected at 1.5% YoY for the Core number. Consumer Confidence is up later today as well. Tonight, we have a Bank of Japan meeting (no move expected there), and an Australia CPI reading, which could further impact the Aussie’s profound recent slide – Australia’s 10-year yield has slide to new lows near 120 basis points – unprecedented levels.
Tomorrow, ahead of the FOMC meeting, we have Germany employment change data and the EU’s first look at Q2 GDP and the flash Jul CPI, as well as US ADP payrolls for July. Thursday is world Manufacturing PMI day and the BoE meets (no interest rate move expected – reserving bullets for knowing what Brexit looks like). Finally, on Friday we get a look at the latest US payrolls and earnings data, as another weak month begins to show the short term moving average for payrolls in decline (although weekly claims not confirming of late).
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As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
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