Vive la Revolution
2017 is a critical year for European politics not to mention the triggering of Article 50 and Trump.
First in Europe, where ECB President Draghi reacted to continued low inflation and inflation expectations by signalling the ECB’s desire to further its current easy policy stance.
Seemingly up for review at the December ECB meeting will be the current program of targeted lending; extending the size, duration, or composition of the current QE bond buying scheme; or even moving the current negative deposit rate further into negative territory. This has seen renewed Euro selling pressure and although some further easy policy is priced in at this point, the risks seem skewed towards a continued weakening of the Euro in the medium term.
Second in the US, we saw the Federal Reserve (Fed) begin to signal the December meeting of the FOMC will be a ‘live meeting’ for a decision to increase interest rates for the first time since June 2006. Rhetoric continues to indicate that the Fed is looking to begin raising interest rates in 2015 and with one meeting left, and hot on the heels of a bumper Non-Farm Payroll jobs number, markets are moving to price in a rate rise. On the assumption the Federal Reserve increases interest rates (the Investec Economics team’s main scenario) the question will be the timing of further interest rate rises as to the magnitude of subsequent US Dollar buying, and the implications across the board. Either way, a stronger US Dollar would be the main scenario after an interest rate hike.
Third in the UK, where ‘Super Thursday’ brought a dovish tone from the Bank of England. A strong currency and a persistently low inflation outlook combined to see MPC members broadly validate market expectations for a rate hike not taking place until late-2016. On the day we saw a dramatic weakening of the Pound but the Queen’s finest is already bouncing back. As US yields are rising in expectation of tighter Fed policy, UK yields are following. This can be seen in the attached chart - (UK 10yr Bond yield (white line) following US 10yr bond yield (yellow line) higher). The market, apparently, is not so concerned with Governor Carney’s dovish message, and believes UK policy will follow its US counterpart closer than the Bank of England appeared to imply last week. This is leading to some renewed Sterling buying that could extend in line with US monetary policy.
This time last week, before the Bank of England’s dovish rhetoric I would have been convinced we could see the Pound strengthen to 1.4500 quite quickly - and perhaps as far as 1.5000. The diverging monetary policy outlooks of further ECB easing and a potential H1 2016 UK rate hike should continue to drive the pair higher. With the Bank of England stepping away from ‘following the Fed’, for now it would be prudent to expect a less pronounced move if we continue on our path higher.
This means in the next few months, further gains for the pair would likely be made by aggressive ECB easing with 1.4500 likely to cap in the absence of large scale ECB action. I would expect as we move into Q2 2016 the battle between increasing UK inflationary pressures and when ECB easing will see improvement in Eurozone data will be the key to how far the pair can go before reaching its high of the trend and starting to retrace towards more familiar levels.
If the Federal Reserve increase interest rates (a driver for currency strength) in December for the first time since the onset of the Financial Crisis, there is a risk the US Dollar continues its outperformance that began in mid-2014 ahead of the Scottish referendum in the UK. In the short term, how much lower the pair can move will depend on the magnitude and speed of US rate rises, with key levels if we break below 1.5000 including the 2015 low of 1.4565 and 2010 low of 1.4230.
As we move into 2016, we should see inflationary pressures begin to build in the UK, and as financial markets are beginning to show, we may see the UK ‘follow the Fed’ with interest rate increases of their own. This would see the Pound recover back above the key psychological 1.5000 level to again trade at the current, more familiar levels, in the mid-1.5 handle.
The world outside these four walls the big news is that EU leaders managed to come to an agreement in the early hours of the morning on how to deal with rescued migrants.
As luck would have it, when I hit shuffle on my Spotify this morning Mungo Jerry’s “In the Summertime” came on.
Is it a bird? Is it a plane? Well your second guess was close enough, it’s a 3rd runway for Heathrow.
On the last trading day of the week, the most notable development in markets was a sharp lift in crude oil prices, with WTI and Brent rising 4.6% and 3.4%, respectively.
The pound inched higher yesterday afternoon as news broke Theresa May had managed to avoid a Tory rebellion and avoid defeat in Parliament over her flagship Brexit bill.