Category Archives: Brexit

GBPSEK selling opportunity

The Turkish crisis and Brexit muddle create an opportunity to sell GBP/SEK

 

Turkish crisis dominates the action

This month global markets are mostly concerned with Turkey, with the sharp fall in the currency the main driver of concerns about deteriorating credit quality due to large net external liabilities. The degree to which foreign currency debt of Turkish entities is currency hedged is unclear, but is key for determining their solvency. Other than the weakness of the currency, the economic situation is in any case vulnerable, but has been for some time. But from a baseline of vulnerable, conditions have deteriorated steadily in the last year or two, with inflation rising and the current account deficit widening, in part because the central bank has not been allowed to make the rate rises required to stem these trends. This political aspect of the problem makes it much more intractable, especially when you throw in the pastor and the aggressive tariff response from Trump.

It is hard to see the endgame at this stage. Funding the current account deficit will remain very difficult as long as there is no action. Even significant interest rate rises may not help much at this stage. Capital controls may come in, and there are risks of default on external debt. However, most of the risk is not government debt, as in previous crises, but corporate debt. This makes a bailout unlikely and difficult, but also probably reduces contagion risks. While there is significant exposure to Turkish debt among European banks, it is not game changing – even the most exposed banks would survive the worst case scenario as long as the problems remain isolated to Turkey.

Which leads to the main question, which is one of contagion. Most commentators argue that this is the primary risk, citing parallels with previous EM crises, notably Asia 97. And they are right, because markets are never entirely predictable, and if appetite for risk disappears what currently appears a perfectly solid investment can quickly become vulnerable. (Almost) everyone needs to raise money, and in such circumstances even perfectly solvent entities can struggle to refinance if markets suddenly become unprepared to fund. As Hamlet says “there is nothing good or bad but thinking makes it so”, and shocks like Turkey can lead to some pretty muddled thinking.

Nevertheless, we doubt that the Turkish situation will lead to a big global meltdown in EM, or a renewal of the Eurozone crisis. Even worst case scenarios should remain contained.  While we may have a period of pressure on some EM currencies and higher EM yields, in the end the global economy is starting from a position of reasonable health driven by good US growth and improving Eurozone growth, combined with a generally more solid global banking system. There are savings looking to be deployed towards higher yielding assets in a world of still very low yields. There are no certainties, but this episode looks likely to present an opportunity to buy risky assets. Of course, care is required, as especially in August things can go a lot further than we would expect before turning. Things that look cheap may yet get a lot cheaper, so technical signals that the market has completed its rout need to be awaited.

Opportunities created by Turkish crisis

The obvious opportunities are the emerging markets that have suffered in sympathy with the Turkish Lira. The ZAR, BRL, and even MXN have all weakened, and there may well be value there. But getting these right requires good timing and a clarity that the crisis is over. In these situations it is often better from a risk/reward standpoint to consider the less obvious collateral damage. In the G10 space the two currencies that have suffered the most since early August are the NZD and SEK. The NZD is understandable as it can be considered the closest thing to an emerging market in the G10 space. But the SEK? Sweden has a current account surplus, very low interest rates and inflation, the strongest growth in Europe and a very secure budget and banking system. It is no-one’s idea of an emerging market. Nevertheless, the SEK does tend to exhibit characteristics of a risk positive currency. This is in part a historic issue harking back to the days when Ericsson made up 30% of the value of the Swedish equity market and it was strongly identified with the tech boom and bubble. But nowadays, while still showing one of the strongest growth rates in the EU, there is no particular dependence on tech. Both EUR/SEK and USD/SEK have risen to levels that have to be considered excellent longer term value regardless of which way the Turkish crisis is resolved, but GBP/SEK may represent the best trade, given the risks involved in the run up to the Conservative Party conference and the October EU Summit.

With the UK parliament on holiday, there have been no significant developments in the last couple of weeks, but there has been more and more noise suggesting that the risk of a “no deal” Brexit is increasing. The main upcoming events are the UK Conservative Party conference from September 30 to October 3 and the EU Summit on October 18/19. Neither looks likely to provide any real progress on Brexit, and the prospect of “no deal” will consequently become even more probable, at least as far markets are concerned.

There are several reasons for the lack of progress, but the two main ones are the lack of any majority in the UK parliament for ANY Brexit plan, and the perception on both sides that the threat of “no deal” – and the brinkmanship involved in that – is necessary in order to get the “best” deal for their side. It may be that an apparent increase in the probability of “no deal” is actually a necessary condition for a deal to be done, but the process will nevertheless have continued market impact.

For what it’s worth, we believe that a free trade deal of some sort is the most likely eventual outcome in the Brexit process. Probably the best reason for this is Ireland. “No deal” would require a hard border, and that is anathema to both sides as well as effectively contravening the Good Friday agreement. But even though a free trade deal is likely eventually, that doesn’t matter right now because it isn’t the most likely next step. More stress is required to produce that outcome.

From a trading perspective, the battleground is GBP. We look to play this from the short side not only because the next events look likely to be GBP negative, but because GBP is starting from a position which we regard as barely below fair value. The current price does not adequately reflect the risks of Brexit.

GBP/SEK looks an attractive vehicle to express GBP weakness here.

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GBPJPY hitting selling area

Forget about Brexit for the moment. We don’t know what it will look like, when it will happen or what the global story will be when it does happen. Let’s just look at where the currencies and economies are now, and ask if that position makes sense. In the case of GBPJPY, it doesn’t.

The market is being asked to finance an annual  relative current account position between the UK and Japan of more than $300bn in Japan’s favour, but is being offered no real yield advantage to do so, and GBP/JPY is already relatively expensive relative to PPP and to history. So even without worrying about Brexit, it’s pretty hard to make a case for GBPJPY to be at current levels.

GBPJPY is currently trading around 152. Is that high or low? Well, if you just look at a normal chart, you might think it’s low, because GBPJPY has been falling for the past – well – forever. Even in the past 20 years it has round about halved in value. Though it is around 30 figures above its all-time low (see chart below).

gbpjpy

But this is entirely a nominal picture that ignores inflation. Most of the reason for GBP/JPY’s decline in recent years has been the higher inflation in the UK relative to Japan. The easiest way to illustrate this is to look at GBP/JPY relative to GBP/JPY PPP, as shown in the chart below.

 

gbpjpy and ppp

Source: OECD, FX Economics

So although GBP/JPY has been falling steadily, it is now trading above PPP, and is further above PPP than its average over the last 20 years, as shown in the chart below.

gbpjpyppp

Source: OECD, FX Economics

So, in real terms GBPJPY actually looks quite high compared to history.

Is this justified? Looking at the data, the simple answer is no. UK real yields are not relatively attractive. At the 10 year tenor, the nominal spread is 1.2% in favour of the UK. But the inflation differential in 2017 was 2.6%. Even though this is expected to narrow in 2018, it is still expected to be 1.6% according to OECD forecasts. So real yields actually favour Japan and the JPY (even more so at the short end of the curve where nominal spreads are smaller).

What about other determinants of cross border flows? The current account position implies a need for a cross border flow, and the UK was in deficit in 2017 to the tune of about 4.7% of GDP, while Japan was in surplus by 3.9% of GDP. This difference is only expected to narrow very marginally in 2018.

So the market is being asked to finance a relative current account position of more than $300bn, but is being offered no real yield advantage to do so, and the currency is already relatively expensive to PPP and to history. So even without worrying about Brexit, it’s pretty hard to make a case for GBPJPY to be at current levels.

If we add Brexit into the mix, it’s worth noting that GBPJPY is now above the high it traded the week before the Brexit referendum. Whatever you think about Brexit, it is pretty hard to argue that it currently justifies a stronger currency.

So much for valuation. But a large part of this story is about the weakness of the yen rather than the strength of sterling, and the weakness of the yen has historically been well correlated with positive risk appetite, reflecting the historic tendency for the surplus country to be keener to place money abroad at times of positive risk sentiment. But this makes far less sense than it used to when the real yields available outside Japan are no greater than the yields available inside Japan.

So it seems to me that these represent excellent levels to sell GBPJPY for the medium to long term. For the technical minded. 153.80 represents the 76.4% retracement of the move from the 164 May 2016 high to the 123 October 16 low.

Rate hike won’t sustain GBP strength

I’ll make this short because I’ve covered this ground in this blog before, but recent gains in GBP in response to the latest inflation data and the more hawkish tone from the Bank of England at the September meeting make it worthwhile to go over it once again.

First, the basics. Higher inflation, other things equal, should mean a currency goes down, not up, in order to maintain the relative price level. The fact that currencies tend to rise in the short run with upside surprises in inflation is an anomaly seemingly based on a combination of money illusion and a historic expectation that higher inflation will trigger a response from the central bank that will actually mean higher real interest rates. This seems to be a distant memory of the 1970s and 80s, because it is hard to find occasions in the more recent past where higher inflation has triggered higher real rates (as opposed to just higher nominal rates) in the major economies. Of course, real rates have been falling steadily for years as a result of structural as opposed to cyclical factors, but even the cyclical upturns have seen precious little rise in real rates (see the FX market needs to rethink inflation, November 18 2016).

All this is relevant to the recent reaction to UK news. Inflation is above target and still rising, mainly in response to the decline in GBP seen after the Brexit vote. The MPC is now considering a rate rise in response. But the rate rise will come nowhere near full compensation for the rise in inflation seen since the Brexit vote. Real rates have fallen, and even if we see a 0.25% rise in the base rate soon they will still be well below where they were not just before the Brexit vote, but immediately after the BoE cut in rates after the vote (see chart below). While inflation has also risen elsewhere, it has not moved as much, and UK real rates remain unattractive, and will remain unattractive even if they move modestly higher.

Real UK base rate

uk real rates

Source: Bank of England

On top of this, there is the question of whether higher real rates in these circumstances, if they were to come, should be seen as positive for GBP. In general, higher real rates are theoretically positive for a currency, but in the current UK situation Carney’s speech yesterday makes it clear that his case for higher rates is based primarily on the expected inflationary consequences of Brexit. This is not the usual cyclical impact of rising demand, but a structural change that will reduce both demand and supply and raise prices, at least in the short run, with Brexit effectively acting as a de-globalisation. Carney’s case for higher real rates essentially rests on the belief that the Brexit impact on supply will be greater than the impact on demand. This is debatable (as he himself admits) and it is hard to instinctively see this as positive for GBP, because real rates will be rising because of reduced potential output due to reduced efficiency and lower productivity. Any benefit from higher portfolio inflows to seek out the higher real rates seems likely to be offset by reduced inward direct investment as a result.

In summary, the case for GBP gains based on a more hawkish BoE seems very weak. Any rise in nominal rates looks unlikely to translate into a rise in real rates, and to the extent that real rates are higher than they would have been, it will likely only reflect the Bank’s concern that Brexit is going to undermine potential UK output growth by reducing productivity and undermining existing supply chains. Of course, that doesn’t mean GBP will reverse recent gains quickly (the market can remain irrational longer than you can remain solvent), but looking at the charts suggests to me that 1.38 would be a very good area to sell GBP/USD, while anything below 0.87 looks a buying area for EUR/GBP.

The UK needs a weak pound

UK Chancellor Philip Hammond welcomed the rise in the pound that accompanied the announcement of the UK election last month. He should be careful about cheerleading GBP strength, because right now the UK is more in need of a weak pound than it has been for a long time, and a significant recovery in GBP could be a big problem for the UK economy.

The UK economic situation is dangerous, not only because of Brexit, but because of the perilous position of the UK’s consumer finances. This is well illustrated by the chart below showing the financial balances of the three sectors of the UK economy, balanced by the position with the rest of the world.

sector balances

Source: ONS

The UK household deficit is at record levels, and as can be seen from the chart, the existence of a deficit is a rarity, seen only briefly in the late 80s and then for a few years in the mid 2000s. It is a danger signal. In both cases, the deficit was followed by a recession, as consumers retrenched, as can be seen from the chart below.

householdbalance and GDP

Source: ONS

The process see in the past is instructive. Most of the time, GDP grows as the household balance moves towards deficit, fuelled by deficit spending. However, when the household balance moves into deficit, it tends to reverse, and this has historically led to a recession. If this is not to happen this time around, the inevitable reversal in the household balance must be accomplished slowly while other sectors are adding to growth. With the government constrained by longer term budget issues, this really only leaves investment and net exports. This makes the danger from Brexit fairly obvious. If firms are worried about access to the single market then investment in the UK may be curtailed. Longer term, the terms of Brexit will be key for net exports, but shorter term, the export sector looks likely to be the healthiest, as UK exporters benefit from the combination of a lower pound and strengthening Eurozone domestic demand. But this is why a significant recovery in the pound is not desirable. It would both undermine export growth and discourage investment.

Is a recession inevitable when households retrench? Not necessarily – it will depend on the conditions. In 2000 when the dotcom bubble burst the UK avoided recession in spite of a very extended household sector which did retrench, because rate cuts encouraged firms to borrow. But this underlines how important business confidence is in the current UK cyclical situation. With no rate cuts available to encourage businesses or households to spend, confidence in the future is key if spending is to be maintained.

All this makes the timing of Brexit look extremely inopportune. In the mid 2000s, the household sector ran a financial deficit for a few years before the crash, but the crash was all the more severe when it came for that reason. If growth is maintained in the coming years ahead of Brexit, the situation will be similar when Brexit actually happens. If Brexit hurts exports and investment, there will be no safety net.

Policywise, this should make it clear to the government that “no deal” with the EU is not an option. The fear is that they will  believe their own publicity and see limited economic damage if they fail to get a deal. Or take the view that, politically at least, falling back on the WTO will be favourable to accepting a deal that is like EU membership only worse. Hopefully sense prevails.

But in the meantime, the UK economy needs to be managed into a position where it can deal with a potential shock. This means managing a retrenchment of household finances now – while exports are strong enough to offset the negative growth impact. Unfortunately, it is hard to think of a policy mix that will achieve the desired outcome of slower consumer spending with strong exports and investment. Higher rates would help increase saving, but would also likely undesirably boost the pound. Higher taxes wouldn’t reduce the household deficit, only consumer spending, but would give the government more scope to react to shocks in the future, so are probably desirable. Direct restrictions on consumer borrowing might also make sense. But a stronger pound would not be helpful. Hammond should not be talking it up.

UK retail sales – the beginning of a slump?

Unusually I think it’s worth highlighting a monthly release. There is a lot of randomness in most monthly data and UK retail sales is one of the most vulnerable to monthly glitches, often because of seasonality problems. However, if you look at a 3 month average of sales the trend has been quite clear in recent years, until the last couple of months where it looks like everything fell off a cliff.

uk retail

Source: ONS, FX Economics

Now, it’s as well to be cautious in interpreting such sharp moves in retail sales, especially around the turn of the year when Christmas effects can be unpredictable. The plunge we have seen is really based on just a couple of months data. But as can be seen from the series, it is rare for the 3m/3m trend to move so sharply. If we see a similar story in March it would be fair to conclude that there has been a clear weakening in the trend.

Which leads me to the March data due for release tomorrow, Friday April 21. Looking at the screens today, the market median expectation for retail sales is for a m/m decline of 0.2% in the headline number, and a 0.4% decline in the core. Now, this seems to me to be quite a pessimistic forecast. The impact on the 3m/3m growth rate would be minimal, as shown below.

UK retail march

Source: ONS, FX Economics

Retail sales only makes up around 40% of personal consumption, but even so, a 1.2% decline in a quarter is quite a serious slump. Even if we assume the rest of spending carried on as before at the 0.7% q/q rate seen in Q4, then this would still mean negative consumer spending growth in Q1. As I was last month, I am a little sceptical that spending has been quite that weak. Last month we got a rise of 1.4% m/m, which was still far too little to prevent a sharp weakening in the 3m/3m trend, but was nevertheless well above the monthly forecasts. Markets saw this as good news, simply because the outcome was better than expected on the month, but it’s very hard to see how this sharp weakening in the retail sales trend is actually positive news for GBP. This month we may get more of the same. It would take something above a 3% m/m gain to prevent retail sales falling q/q in Q1. But a better than expected outcome of a 1% rise or so seems quite likely, as this would still mean a fall of 0.75% q/q. But surveys don’t suggest any major recovery, with the BRC survey showing the weakest quarter since May 2011 for non-food sales.

So we might get a knee jerk positive reaction because the monthly forecasts once again look quite weak and the m/m rise may be better than forecast. But any positive GBP reaction could prove a selling opportunity for GBP as the strength of the UK economy that Theresa May and the IMF have been telling us about in the last week looks to have come to something of a shuddering halt in Q1. Who knows, this may be another reason that May has called an election now. There are initial signs of a slowdown, and she may want to get an election in now in case they become more obvious in the coming months and years. We are in the sweet spot when it seems consumer confidence is still high, or at least was until Q1, exports are getting some support from a weak pound and there are as yet no negative consequences of Brexit to deal with. Things might not look so rosy in a few months.

UK election – GBP surge may last a while but…

maycorbyn

So May calls and election, saying she’s fed up with having opposition from the – er – opposition, and also from the Lords. Someone should tell her an election isn’t going to have much impact on the unelected House of Lords, but it’s true it may have the desired effect on the House of Commons. In practice, she is likely to increase her majority because even though she may lose a fair few seats in the South to the Lib Dems campaigning on a Remain ticket, she looks like picking up a lot of Labour seats in the North, and also gaining votes from UKIP now the Tories have become the party of Brexit.

What I find depressing is the process of British politics. I suppose it is no surprise that politicians are power hungry – it is in their nature – and they will grab as much as they can given the chance. That is probably true pretty much everywhere, but let’s not pretend there is any higher motive for the election than that. But it is particularly depressing in the UK, where the first past the post system means the governing Tory Party already has a degree of power that is unrivalled is the vast majority of western democracies which generally have some form of proportional representation. The desire for an even bigger majority than the 17 the Tories currently have, so that there is no effective opposition at all (even within the Tory Party) is, in my view, faintly obscene, but that’s (British) politics. What is mystifying is why Corbyn and the Labour Party seem so happy to accede to her wishes. Sure, he was calling for an election after the referendum, but she refused. Now he should refuse. That’s the point of the Fixed Term Parliament Act. The timing of the election should not be based on the whim of the governing party (or any other party). His agreement to an election just underlines that Corbyn is a political idiot.

Anyway, it looks like May will get her wish and get an election and a bigger majority. The market consensus is that this is a good thing in practice, because it will give her more negotiating power at the Brexit table. This is true, in that there will be no election looming over her as the end of negotiations approach. However, the idea that she will take a more moderate and compromise friendly approach because she will be less dependent on her right wing looks a little speculative to me. It’s possible, but I don’t detect an air of compromise in her recent statements. I think it’s just as likely that the elimination of an effective opposition will allow the government to take a much more hard line approach. The security of the Conservative political situation domestically will allow them to indulge prejudices that are not necessarily optimal for the long term health of the economy.

While she will of course say she wants the best deal for Britain, what does that actually mean in practice? No-one really knows what the best deal is. Although the vast majority of economists believe something as close as possible to Remaining would be best economically, it is clearly not just about economics. In fact, it is probably not about economics at all. For politicians, the best deal is the deal that will given them the best chance of winning the next election with the biggest majority. The economic impact of Brexit may be large or may be small, but it will not be easily observable because there is no counterfactual. We won’t know what a good Brexit looks like any more than what a bad one looks like. We won’t know if Remaining would have been better. Even if the next election isn’t until 2022, the economic impact very likely won’t be clear by then.

But some things will be easier to measure. The level of immigration for instance. If the government manage to restrict immigration significantly they will probably benefit in the polls (regardless of whether that is actually beneficial). If they win the June election with an increased majority it seems likely to send them a signal to continue to work the nationalistic angle. This is not a conviction government. May has U-turned on Brexit and U-turned on an election. She will go with what works, and if she can sell an image of the UK battling for independence from a sclerotic Europe she will do it. I could easily be wrong here, but markets must beware of believing politicians are thinking about the economy. They are thinking about politics, and right now the economics isn’t clear enough (at least to the layman voter) for that to be the main factor.

As far as FX is concerned, for now at least, there’s no point bucking the market consensus. GBP is benefiting from the more positive view of Brexit, helped in large part by the heavy short positioning that has been evident for some months in the futures data. Some of that has now been eliminated, but the wind is still with the pound. I stick with the view that there isn’t much long term value in the pound here, but there may still be some more upside in the short term. In the absence of news from the US on tax reform the USD looks to be on the back foot for the moment, with expectations of Fed hikes fading, and we are likely to see GBP/USD gains beyond 1.30.  The EUR’s near term chances depend largely on the French election. If Macron gets to the second round he should win and the EUR should benefit modestly from this, but will suffer sharply if the run off is between Melenchon and Le Pen. On the positive EUR outcome I would see EUR/GBP as a buy below 0.83.

Looking a little further forward, the election may not be quite as smooth a victory as the polls currently suggest, and the current perception of the strength of the UK economy seems to be lagging behind what looks like a fairly sharp consumer slowdown in Q1. I would still be looking to sell GBP post election, or possibly before if the current euphoria dies down or we have some positive developments for the EUR or the USD.

 

A strange time to worry about the euro

An interesting survey from Central Banking shows central bank reserve managers have apparently lost faith in the euro, with the stability of the Eurozone supposedly this year’s greatest fear. Apparently concerns over political instability, weak growth, and the European Central Bank’s (ECB) negative interest rate policy have led central banks to cut euro exposure, with some eliminating it completely. This strikes me as very strange timing.

Now, there is of course uncertainty about the Eurozone. But it seems odd to me that these reserve managers have chosen this year to start worrying. Where have these guys been for the last 9 years? There has been uncertainty surrounding the Eurozone since the financial crisis (and before). Greece’s woes have hardly been a secret – they have had two debt restructurings in the last 5 years. Yields in the Eurozone periphery blew out to extreme levels when the Greek crisis was at its height, reflecting concerns about Eurozone break-up. Back then, concerns were not confined to Greece either – Spain and Portugal were also very much in the firing line. By comparison, the current bond market spreads show very little evidence of worry about Eurozone break-up. So why are the central bankers in a tizzy all of a sudden?

One of the reasons they give is the negative interest rate policy from the ECB. It is understandable that investors aren’t happy with this, but it is hardly a new phenomenon. The deposit rate went negative in mid-2014. Furthermore, concern on this issue shows a worrying degree of money illusion. Using the OECD’s forecasts for 2018 inflation, the table below shows real interest rates across the G10.

real yieldsSource: FX Economics, OECD, national central banks

On this basis, the real policy rate and real 10 year yield for the Eurozone (using France as a proxy for the 10 year yield) aren’t really that low by international standards. In fact, the real policy rate is higher than in both the UK and US. I have ranted about money illusion many times before, so I won’t bore on, but you would have hoped that international reserve managers were a little bit more savvy than to look just at nominal rates.

So maybe they are worried about politics. I find this ironic. The UK votes for Brexit and the US votes for Trump and reserve managers are worried about politics in the Eurozone? It’s true that the Eurozone is existentially more vulnerable, and therefore you can regard political instability as more dangerous. But in reality the chance of a Le Pen victory in France is tiny, and even if she did win, the chance of France leaving the EUR given she has no parliamentary support is similarly tiny. The bigger danger is Italy, but again, despite the anti-euro lead in the polls, there is unlikely to be an election this year, and forming a coalition that would genuinely be prepared to take Italy out of the EU would be extremely difficult. Of course, Italy leaving would be disastrous (for Italy but also for the EU) so this is not a scenario that can be taken lightly. For this reason it is also extremely unlikely to happen, but that doesn’t mean there wouldn’t be major market concerns if the possibility started to look more real. Nevertheless, it is surprising that yield spreads haven’t blown out much further is this was a genuine concern.

As for weak growth, this has been an endemic problem in Europe, but it is again strange to worry about it now when Eurozone growth is picking up and looks set to record its fastest rate since 2010.

There is no doubt that the EUR has suffered from a lack of foreign capital in the last year. In 2016 there was a reduction in Eurozone portfolio liabilities of EUR66bn – foreigners sold a net EUR66bn of Eurozone assets – compared to net buying of nearly EUR400bn in 2014 and Eur300bn in 2015. As long as this continues – the net portfolio and direct investment outflow more than offsetting the current account surplus – investor concerns about the EUR are likely to be self-fulfilling. But I am not sure how long this attitude can last. The EUR is already very cheap by long term measures, and the economy appears to be picking up. If Le Pen loses – as seems very likely – I suspect it will be hard for the markets to maintain this negative attitude indefinitely. But then I don’t really understand why reserve managers have turned so negative in the first place.