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.

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.

GBP isn’t cheap

Over the last few weeks and months I’ve noticed quite a few commentators suggesting that GBP might now be attractive because it is very cheap. For instance “the pound looks increasingly “cheap” in a historical context” (Morgan Stanley March 7). “The pound looks cheap at current levels” (ANZ December 6). “The pound is looking “cheap” from a longer-term point of view” (Scotia Bank March 2). There are plenty of others. The consensus seems to be that the pound is cheap because it is suffering from Brexit woes, and that if those were to fade, or be overtaken by concerns elsewhere in the world, the pound would recover. But I would argue that although the pound is obviously cheaper than it was, it still isn’t really cheap against most of the other major currencies.

If something falls a lot it doesn’t necessarily mean it is now cheap. It’s possible of course. But it is also possible that it is falling in line with long-term equilibrium – i.e. it is no cheaper than it was. Or, more likely, it could be that it has fallen from expensive levels and is now just less expensive, or fair. How to decide? Well, some sort of sensible model of fair value is necessary, otherwise we don’t know where we are starting from, or what affects long term equilibrium.

A lot of people run a mile as soon as they see the word “model”. Models are distrusted. So I’m not going to create anything complicated or use any fancy econometrics. I’m simply going to point out three things.

  1. It is the real value of a currency that matters, not the nominal value. This is just another way of saying that if prices rise in one country or currency area relative to others, then unless the currency falls, things are now more expensive in that country/currency area. In other words, to keep the real value of the currency stable, currencies have to fall if relative inflation is high in their area.
  2. Trade balances and current accounts matter. The bigger your current account deficit the more capital you need to attract to finance it and, other things equal, the lower your currency has to be.
  3. Interest rates make a difference. If you have higher interest rates than others there will be more demand for assets denominated in your currency. This ought to apply to real interest rates (interest rates minus expected inflation) rather than nominal rates, because future inflation would typically lead to currency depreciation (point 1).

I don’t think anyone would argue with these three points. But if these are accepted, I don’t see why people see GBP as cheap.

Point 1 is really the most crucial. While terms of trade and interest rates are clearly important, the impact from changes in export and import prices can take some time to be felt and can be offset by other flows. Similarly, interest rate variations affect short-term demand, but if such variations are cyclical they may not have much impact on long-term value. But where we are starting from in terms of the real value of the currency is critical.

So where does the pound stand in real terms? There is more than one way to measure this, but I will use two main methods. First, let’s looks at the commonly used measure of the real effective exchange rate. The chart below shows the narrow real effective GBP exchange rate, and on the face of it, GBP does look quite weak by historic standards. But looking at it next to the EUR effective exchange rate, it isn’t so clear. Since the financial crisis the EUR has weakened more on a trade weighted basis than GBP. Even more dramatically, the USD is well above the highs seen in the last 20 years

realeffective

Source: BIS

So what’s going on? Well, a little more light is shed if we look at another measure of value – namely GBP versus purchasing power parity (PPP). Below is a chart of EUR/GBP against EUR/GBP PPP.

eurgbp ppp

As this shows, EUR/GBP remains some way below PPP. This is not unusual – it has only briefly traded above PPP in the past. This is itself a little puzzling, and I would argue that it is hard to justify, of which more later. But even taking that as given, EUR/GBP is only marginally stronger relative to PPP than its average in the last 20 years.

So GBP isn’t really weak against the EUR at all. What we are seeing here is not GBP weakness, but USD strength.

This is all the more obvious if you look at GBP/USD relative to PPP, shown below.

gbpusdppp.png

The USD is as strong against the pound (relative to PPP) as it has been since the 80s and the Reagan era. But the USD is strong against (almost) everything. Only the CHF among the majors looks stronger relative to long run fair value.

Now, USD strength is based on the cyclical strength of the US economy, and to that extent is justified in the short to medium term because US interest rates are higher than the UK and Eurozone, and rising. While the UK economy is (arguably) similarly strong to the US, given low levels of UK unemployment, the UK doesn’t have the interest rate advantage. Indeed, real UK rates are the lowest in the G10. Not only that, but the UK also has a massive trade and current account deficit. The chart below illustrates the situation.

yieldcascatter

Source: OECD. Real rates based on 2018 forecasts of PCE deflator

The further north-east you can get in this diagram, the more attractive your currency should be. A big current account surplus, like Switzerland, will normally allow you to have low real rates while high real rates, like New Zealand, will normally allow you to run a big current account deficit. The UK is currently enjoying the worst of both worlds. It’s also noticeable that real rates in the US aren’t all that attractive, and may not be high enough to justify the very high level of the USD. As far as the EUR is concerned, there are clearly other issues at play, including existential concerns. But without even considering the potential future negative impact of Brexit (though of course some of this is included in the real yield), it would make sense for GBP to be well below fair value. The fact that it still trades well above PPP against the EUR, and close to it against the USD, suggests it is far from cheap.

Policy mistakes should not always be reversed

cpimktfeb17-1

UK inflation is rising

The Bank of England cut rates by 25bp and increased asset purchases in August in anticipation of a loss of confidence after the Brexit vote on June 24. The objective was stated to be to “provide additional support to growth and to achieve a sustainable return of inflation to the target.” Subsequently, growth was substantially stronger than expected through the remainder of 2016, mainly due to strong consumer spending, funded by increased borrowing. Now, many (including myself) thought the cut was a mistake at the time. But we all make mistakes. The Bank’s assessment of the impact on confidence appears to have been incorrect. Of course, some might argue that growth was stronger because the Bank eased policy, and no-one can prove that is wrong, but I think it is far-fetched. The fact is that the majority of the population (or at least half) are in favour of Brexit, so there is no good reason why the vote should have undermined consumer confidence. Business confidence might have been damaged in the longer run, but very few investment decisions are changed in a short time frame, so if there is a negative impact, it is yet to be felt. In practice, the relative resilience of spending may convince businesses to hold their nerve until the new trade arrangements become clearer, which may well take some time, as long as growth doesn’t start to slip back.

So it certainly seems as if the Bank of England made a policy error. While there is still very likely to be a longer term supply side shock from Brexit, that may not happen for quite some time, and the demand side shock the Bank initially expected has not materialised thus far. So what should they do? Should they reverse their easing and admit their error? The latest Inflation Report certainly shows inflation is expected to move above target soon and stay above target for the whole forecast horizon, which would suggest there is a pretty good prima facie case to raise rates or at least halt the increase in asset purchases. But the best way to fix an error is not always to simply reverse policy. Unless the reversal is done very quickly, the environment faced is different from the one faced initially. Things have changed.

In this case, the most notable change has been the decline in the pound. This has been good in some ways, as it has helped sustain manufacturing an export confidence in the face of uncertain future trade relationships, but it will lead to substantially higher inflation going forward, starting quite soon, as higher import prices feed through to CPI. It has also already led to higher inflation expectations. The key question as to whether this is sufficient reason to reverse the policy easing is whether the coming rise in inflation leads to an increase in wages and other factors generating domestically generated inflation. At this stage this is not clear, and is important. If wages don’t respond, we will see a sharp decline in real income growth as inflation rises, and if we also see a rise in rates from the Bank, there is a danger this will lead to a sharp decline in consumer confidence, potentially at the same time as sterling rises in response to a rise in rates. This could make the current optimism about the UK economy evaporate quite quickly.

So at this stage it seems sensible to wait. Inflation is coming, and it would be as well to see how this impacts spending and confidence before acting to reverse the move made in August. There has been a lot of British bravado since the Brexit vote, but high levels of debt and declining real incomes, plus the uncertainty surrounding the trade relationship with the EU and elsewhere, suggest that confidence is likely to be fragile. After making a policy mistake it is important not to compound it. The Bank mustn’t act looking in the rear view mirror.

 

 

A crisis for UK democracy?

power-of-the-press-5-638

A bit on the markets in a minute, but first a bit of a rant.

If the Daily Mail call High Court judges “enemies of the people” simply for saying that parliament has to sanction the triggering of Article 50, what will it do if some MPs choose to vote against the wishes of their constituents?

This is a difficult issue for some MPs. After all, some are in constituencies that voted to Remain but themselves support Brexit. Others are in Leave constituencies but were in favour of Remaining. The Daily Mail would argue that the people have spoken with the referendum, but the result was close, and had more young people voted might have gone the other way. It might go the other way if it was done again today. So in my view MPs should vote in line with their own views. But they won’t. Even if they are in “Remain” constituencies, and are pro-Remain themselves, very few MPs will vote down a bill to trigger Article 50. Partly because they will be put on the front page of the Daily Mail if they do. And they remember what happened to Jo Cox. This is not a good way to govern a country, and reminiscent of some unpleasant regimes.

Unless MPs are prepared to act as responsible human beings and stand up to their party, the press and the noisy section of their constituents, they are becoming an irrelevance. They are mere ciphers. They are not being allowed to make their own decisions about anything important. It is important to have a role for personal conscience.

The further irony is that Brexit was (according to the Leave camp anyway) supposed to be about taking back control of our government from the EU. But if MPs are effectively just servants of the government, we are effectively being governed by royal prerogative. Come back Oliver Cromwell.

Anyway, rant over. The markets.

Sterling has managed a little rally in response to the High Court decision that parliament has to trigger Article 50, but this doesn’t look like it will be enough to sustain a strong rally in GBP for at least two reasons.

1) Although GBP is now a lot cheaper than it was, it is not dramatically cheap against the USD or the EUR given the big UK current account deficit and the lack of (real) yield attraction available in GBP.

2) Even if the High Court decision is upheld by the Supreme Court, it doesn’t mean no Brexit. Brexit is still extremely likely to happen. There might be some impact on the shape of the Brexit, but even this isn’t clear. If the government sticks to its guns on rejecting free movement and the EU sticks to its guns on making free movement a condition for single market access, it seems doubtful that parliament will really be able to have much real effect. What does seem likely (though not certain) is that there will be a significant delay in triggering Article 50 because of the time it is likely to take to put a bill through the Commons and Lords (average time one year). There could be a simple resolution to speed things along, but this would mean parliament would have to have its say at a later date.

So the vote has created extra uncertainty around Brexit, and has perhaps increased the chances of a softer version and a longer delay. This is mildly supportive for GBP, but some argue that the delay and uncertainty only makes things worse as firms are unable to plan for the future. I’d say this is outweighed by the increased chance of a softer Brexit, but not so much as to justify a dramatic GBP rally. EUR/GBP may manage to get back to the 0.86 area, but unless there is a lot more promise of a soft Brexit or some evidence on Eurozone weakness and/or UK strength gains beyond this are hard to justify. Still, it looks like it might be enough to stabilise GBP in the 0.86-0.91 range.

I have put this in terms of EUR/GBP rather than GBP/USD because coming into the US election the picture for the USD is obviously very uncertain. Most take the view that a Clinton victory will be USD positive, and market behaviour in the run up to the election suggests this is the case, but with a Clinton victory now priced as around an 80% chance, the market reaction may not be huge. The Fed is very likely to hike if markets respond positively – even neutrally – to the election, and that should be enough to sustain the USD against most currencies, though which currencies it gains most against will to some extent depend on the (uncertain) medium term equity market reaction to the combination of a Clinton win and higher US rates.

This is all pretty much the consensus view, and I’m not going to speculate too much on what happens if Trump wins, except to say that I’m not sure the impact will be that sustained. In the end, Washington will put fairly substantial limits on what he is able to do.

EUR weighed down by GBP not Draghi

eurandgbp

Looking at the markets, it seems as if Draghi said that the ECB would be easing further come December, or at the very least March. The EUR has gone into a tailspin since the ECB meeting, and journalists are queuing up to blame Draghi. The trouble is, no-one seems quite sure what he said that triggered the move. One headline said “Euro close to 8-month lows vs dollar Friday after ECB chief Mario Draghi ruled out an abrupt end to QE.” Another headline “Euro wallows near March lows after Draghi quashes tapering talk”. So did he quash taper talk, or did he say the ECB would taper? Because if you don’t end abruptly, you taper (it’s one or the other). And which is better for the EUR? Because when it was suggested that the ECB would taper a month or so ago (by some unnamed committee member that Draghi emphasised had no insight) the EUR went up. So presumably if they don’t taper it goes down? Except Draghi said they would taper. Which I would have thought was sensible, and less likely to be EUR positive than an abrupt end to QE if anyone thought about it. Which all probably goes to show how silly the original “taper tantrum” was, but doesn’t really explain why the EUR has been so weak since Draghi’s press conference, especially since the effects of the initial taper tantrum were fairly short-lived in any case because on reflection most saw that the initial story didn’t mean a great deal, true or not.

In reality I don’t think the market really saw anything new in Draghi’s comments, but in the absence of anything new, the downtrend in EUR/USD remains in place. EUR/USD has been in a downtrend since the Brexit vote, and with the market expecting a Fed rate hike in December and currently seeing a probable Clinton victory as favourable (presumably because it is essentially the status quo – no nasty surprises), the burden of proof is now on those that want to oppose the EUR/USD downtrend. It is interesting that the Brexit situation appears to be the key factor that has pushed EUR/USD lower, though the UK is a small economy by comparison to the US and Eurozone giants. It is certainly the case that EUR/USD has never regained the 1.1377 high seen on June 24 and had been edging higher into the vote. It is hard to see that the economic news form the two economies since then has been particularly USD positive or EUR negative. If anything the opposite is true. Certainly since the beginning of this year the performance of the Eurozone in both growth and inflation has been broadly in line with expectations, while US growth has significantly underperformed. In fact, the OECD currently expect US GDP growth to be weaker than the Eurozone’s this year, and although many expect the Fed to raise rates in December, this is significantly less tightening than had been anticipated  at the start of the year.

So we need some change in market perceptions for the EUR to stop falling, at least until we reach the key levels in the 1.05-1.08 area in EUR/USD. A less negative view of Brexit from the perspective of both the UK and the Eurozone is the most obvious potential trigger, though that doesn’t seem imminent with the EU ruling out negotiation until the UK invokes Article 50, which most likely will be in Q1 2017. The other main possibility is a change in the perception of the Fed, though the way things have turned out this year suggests that even if the Fed don’t raise rates in December, the hit to USD strength may only be temporary unless the ECB turn out to be unexpectedly hawkish at their December meeting. The third chance of a Trump victory is one I hope we don’t have to consider.

GBP weakness overdone?

Well, yes and no. I think the lows seen overnight represent a reasonable idea of the base for GBP, but we may well have another look at them before we go higher. I would argue that while the bad news about Brexit is now broadly in the market, there are few reasons to buy GBP, and levels are still not that attractive, so I would still prefer the downside for now.

The overnight moves were clearly exacerbated by poor liquidity in Asian hours, though it’s still surprising to me that liquidity is that poor. It seems that in the new algo dominated world such moves are becoming more frequent, though it is more surprising in GBP than it was in the CHF when there was a clear change in regime in the removal of a floor. Exotic options structures may have been responsible, but I am not totally convinced by the explanations I have heard.

Anyway, GBP has bounced back after the sharp dip overnight, but buyers will now be even more wary than they were and the prospects of recovery consequently that much less. Was the weakness overnight justified by events? No, in that nothing changed dramatically enough to trigger such a sharp fall. Underlying concern about a “hard” Brexit is behind the negative GBP sentiment, but does this mean GBP is weak indefinitely until the reality of the trade arrangements are realised? Surely not, as we may see no clarity for years. What we are seeing from May, Hollande, Juncker, Merkel et al. isn’t even negotiation yet. The UK hasn’t even triggered Article 50. This is just the pre-negotiation posturing – the trash talk before the big fight. I don’t know what the trade relations between the UK and the EU will look like in the end, but I suspect there won’t be the radical step change in trade that some seem to think. The bad news of a “hard” Brexit is now essentially in the market, so may be there is no more to come and GBP has hit its lows. This is certainly possible, but the problem is that the pound still isn’t particularly cheap.

There is more than one way of assessing value in FX, but I will show three charts here to illustrate why I think GBP is far from being significantly cheap. It is broadly fair against the USD, but it is still expensive against the EUR. I have published these before back in June before the Brexit vote as reasons why, even if there had been a vote to Remain, GBP was too high.

The first chart underlines that GBP is still well above PPP against the EUR. While currencies don’t necessarily trade near PPP, it is a good starting point, and it can be seen from the chart that GBP has generally traded a lot closer to PPP against the EUR than it did in recent years. There was some justification for higher GBP valuation at the height of the EUR crisis, including higher UK yields and greater perceived security, but the yield advantage has effectively vanished and GBP now also looks more risky and less secure, so the justification for trading above PPP is much reduced.

Against the USD the tendency until the mid noughties was to trade close to PPP. Subsequent GBP strength may have been a result of reserve diversification by major central banks (among other things) but current PPP is around 1.32, so we are only marginally below there.

The third chart illustrates how major currency levels versus PPP generally correlate to the size of the current account deficit/surplus in each currency. On this basis GBP looks about fair, while the EUR looks very obviously cheap and the CHF exceptionally expensive. The relatively high valuation of the NZD and AUD reflect their higher yields. The cheapness of the EUR and the high level of the CHF suggests the CHF is the proxy DEM, but sooner or later I expect this will also be corrected.

eurgbppppoctober16

Source: OECD, FX Economics

gbpusdpppoctober16

Source: OECD, FX Economics

fxvalueoctober16

Source: OECD, FX Economics

 

 

 

 

Carney, Prince of pessimism

hamlet

“There is nothing either good or bad, but thinking makes it so”. Hamlet

The most striking thing to me about yesterday’s raft of information and decisions from the Bank of England was the willingness to act on the basis of forecasts of significant near term economic weakness based on, let’s face it, remarkably little solid evidence. This has continued the trend of the Bank supporting the view that the Brexit vote is a disaster and will lead to a major economic slowdown, a view that is becoming self-perpetuating.

Now, of course, the Bank of England has to try to act on the basis of forecasts, and if it merely responds to coincident or lagging indicators of the economy it risks being seen to be “behind the curve” or setting policy “looking in the rear view mirror”. But we are in a unique situation here. No-one has ever left the EU before. We don’t know what the UK trade arrangements will be in the future, and these will in any case not be in place for more than another two years. The Bank takes the view that the ultimate result will be some reduction in UK supply capacity in 2019 and beyond, though it admits the extent of this effect is very uncertain. Fair enough. But the measures announced yesterday were not really intended to deal with this, but with the short-term demand reaction. It is here that I think the Bank is on very shaky ground, for several reasons.

First of all, we should need no reminding that the Bank’s record of forecasting under Carney has been woeful, from the initial unexpectedly sharp decline in unemployment which quickly left his conditions for raising rates looking ridiculous, to the more recent indications that rates were likely to go up rather than down. Carney’s reputation as an “unreliable boyfriend” is therefore to some extent justified, though I would argue his fault is not so much a lack of foresight – as all forecasters know, being wrong is the norm – as suggesting he has more confidence in his foresight and consequently his understanding of the correct policy path than he had any real right to. Of course, there are uncertainty bands around all the Bank of England Inflation report forecasts, but Carney has always tried to provide an impression of greater commitment to a view than these suggest, in contrast to his predecessor Lord King, who increasingly emphasised that neither he nor anyone else knew the answers to many of the questions he was asked.

So it would be foolish to take the Bank’s forecasts as gospel, even in normal times, and one of the main points made by the Bank yesterday was that these were more uncertain times than usual and that there had been “sharp rises in indicators of uncertainty in recent months”. Once again, fair enough, But the Bank goes on to conclude that such uncertainty could lead to a reduction in spending, particularly major spending commitments. Well, maybe, but maybe not. The impact of uncertainty is very – er – uncertain. Uncertainty squared, if you like.

Of course, as former MPC member Charles Goodhart has noted, we always think the situation is uncertain, and this is not an excuse for doing nothing. That only leads to vacillation. The Bank has taken a view that further monetary accommodation is needed because the risks are on the downside. Again, as Goodhart has pointed out, the impact of these measures is unlikely to be very large, as monetary policy has close to run out of bullets, but they are unlikely to do any harm, at least directly.

So my problem is not with the measures per se, or even the broad slant of the analysis, but with the presentation.  The Bank accepts that there is a lot of uncertainty, and worries that this will lead to less spending. But the reaction of people and businesses is not set in stone. It is about confidence and sentiment. The Bank’s policy reaction is not so much about the actual shape of the trade relations in years to come, but the reaction of firms and consumers to worrying about it. The best way of dealing with this is not to say – “yes, things are pretty awful, so here are some measures that might be a bit of a help if things turn out to be as bad as we fear”. It is to take as positive approach as possible, say that we don’t really know what is going to happen down the road, but there is no real need to change our behaviour now as the picture in two or three years time is really entirely unknown. Brexit may not even be the most important thing that happens over that period. For instance, if the Eurozone’s nascent recovery continues, helped by some expansionary fiscal policy, it may swamp any negative Brexit impact (if there is any).

Now, there is of course some need for transparency, and Carney has taken the view that it was the responsibility of the Bank to put out its best guess of the impact of Brexit ahead of the vote. But I feel this was the first error that has been compounded by subsequent acts. You don’t have to believe, like some on the Treasury Select Committee, that there was a sinister political motive behind the Bank’s negative forecasts ahead of the vote, to think that a more humble view would have been far less damaging. If the Bank had merely said that the impact was uncertain and it would react when there was some greater clarity, the idea that a big slowdown was inevitable would not have become so ingrained, and firms and consumers would be less inclined to believe they should put off big spending projects. The latest Bank action might still have been the same, but could have been presented as an insurance policy rather than a reaction to an inevitable sharp downturn. Now we are in danger of talking ourselves into a downturn, and producing a fiscal expansion we can ill afford to offset it.

Perhaps Carney should have spent more time reading Shakespeare rather than learning about DSGE models. Then he would know that “there is nothing good or bad but thinking makes it so”.

Short term risk recovery

blues

“It’s dark, and we’re wearing sunglasses”. The Blues Brothers

So we’re in a bit of limbo Brexit-wise. We don’t know when it will happen (some say even if it will happen), what trade deals will be done, who will be allowed to stay in the UK when we leave, how the elections elsewhere will go, and so on. Still, it is reasonable to say it will have some negative impact on the economy on the short-term. Increased uncertainty will reduce investment by at least a few firms, though it may only be delayed if we finish up with a comparatively benign outcome. I am less sure there will be any direct impact on consumer spending, but the decline in GBP will raise prices and reduce real incomes and spending as a result. Conversely, the impact of a weaker pound on exports may be positive eventually, but not in the short run and perhaps never. While UK exports will be cheaper, it takes time for new orders to be found, and the pound still isn’t cheap enough for the UK to compete in most areas. Plus exports to the EU may suffer because of the lack of any detail on the future relationship. All this is broadly known and in the price, but the extent of the economic impact is very uncertain.

We won’t get any post referendum data until August, and it may be that it is hard to see a clear impact for a few months even if there is a slowdown. So we’re driving if not blind, then at least in the dark with sunglasses on (like the Blues Brothers).

The Bank of England needs to decide this week whether these conditions justify some new action. They have already eased capital requirements on the banks but many think this is just a preamble to a rate cut, as bank profitability will now be partially protected. Carney has said he believes some monetary easing is justified. Many think a rate cut will be delayed until August, but we will know very little more in August than we do now. So I expect the Bank will cut rates this week, though other measures are also possible. It probably doesn’t matter too much exactly what the measures are, as in reality the issue is building confidence rather than adjusting the cost of borrowing.

What will be the impact on the FX markets? If there is no action risk will suffer and with it the pound as well as the other “risky” currencies. If there is a cut an initial dip in the pound may well prove a buying opportunity as risk recovers. The Bank knows that something is expected and is unlikely to take the risk of doing nothing because of the probable negative impact on markets of what would be perceived as dithering. Carney has effectively forced the hand of the rest of the Monetary Policy Committee by saying action is necessary. So look for a bold Bank and a risk positive reaction, especially since the global background is better after the better US employment numbers and the withdrawal of the ludicrous Leadsom as candidate for PM. EUR/JPY (or probably better still, SEK/JPY) seem the cheapest major currency pairs to me. Of course, it may not last if the economic impact of the Brexit vote turns out to be very negative, or if the negotiations between the UK and Juncker and co. break up in acrimony. But for now, while the outcomes are unclear, expect a risk recovery as the Bank tries to build confidence.

Over to you Angela

merkel

After the vote for Brexit, everyone will be talking about what happens next, what trade deals the UK can cobble together, how we deal with the collapse in the pound. But these economic problems are all soluble. Some of them aren’t even problems. The devaluation of the pound is 100% welcome. OK, it might have been better if it had happened slower, but the pound has been overvalued for years, and the drop only takes it back to something close to fair against the USD. It remains quite expensive against the EUR (see previous blogs). I wanted to sell GBP whether we voted in or out.

Trade deals are a bigger issue, primarily in the area of financial services. However, my belief is that in the end it won’t be in most people’s interests to change things too much. The passporting issues with Europe may make some things difficult for international banks headquartered in London, but won’t change the fact that the talent and the infrastructure are in London. In practice business will be done in the places with the greater comparative advantage. London may suffer a bit, but I sincerely doubt that Paris and Frankfurt will be taking over.

The economic issues may create some short-term pain, but regardless of the various studies out there from supposedly independent institutions, we simply don’t know the long-term impact, mainly because it depends hugely on politics. It is the political fallout from this that will be the key longer term determinant of the impact both on the UK, Europe, and the world as a whole.

In the UK, Cameron is going anyway at the end of this parliament. He may well have to go earlier. It seems likely that he will be replaced by a right-winger, though the Tory Party may try to find someone to bridge the rifts. Theresa May could be the closest thing they have. But it is far from clear that the Conservatives will win the next election.  They are likely to suffer losses to UKIP, and Labour may do better than many think, though in the end Corbyn still seems likely to be a liability.

But more important is what happens in Europe. Will Brexit prove to be a trigger for similar votes in the Netherlands, Denmark, even Italy?  This seems to me to be the crucial question. The EU is not loved in many countries at the moment, and their reaction to the UK vote may now determine whether the bloc survives in its current form. If they follow through on the threats to make things difficult for the UK, it may discourage others from exiting, but it could also backfire. The votes who want to leave are a little bloody-minded by nature. Attempts to assert central control from the EU make anti-EU movements more rather than less powerful. It could also crucially damage confidence. The markets and business now desperately need reassurance. They don’t want to see increasing difficulties in doing business.

From an FX perspective, I would expect the initial response of GBP to broadly stick. The big question is now what happens to the EUR. A moderate response from the EU which attempts to build bridges with the UK would be positive for world markets and for risk. Attempts to punish the UK will be negative for risk assets and negative for the EUR. The EUR is already a cheap currency at these levels, but the economy is fragile and the EUR can get cheaper if leaders mishandle the situation and fail to support confidence.

So it’s over to you Angela and Francois. Accept a new European landscape with grace and forgo all thoughts of punishment and protection and this need not end badly. Try to tighten the reins on the rest of Europe and strike fear into potential exiters and it will finish the worse for everyone.

GBP a sell on the news

Coming into the final week ahead of the Brexit vote, GBP has been given a fillip by the weekend polls, which showed a recovery in the “Remain” vote even in polls done before the tragic murder of MP Jo Cox. The latest Survation poll showed Remain 3 points ahead, while the others over the weekend broadly showed the camps neck and neck. GBP has rallied sharply on the news, and will probably gain some more, if, as I expect, Remain continues to gain ground into the vote. In the end, in spite of concerns about lack of sovereignty and a (largely justified) deep mistrust of the EU and its institutions, the fear of the unknown and the warnings of the economic consequences of Brexit are likely to hold sway. It’s not a certainty, but I would be wary of betting against Remain ahead of the vote.

But after the vote is a different story. As I have noted before, while there is a perceived risk premium in GBP, the pound isn’t cheap even with this risk premium. On the contrary, it continues to trade well above PPP against the USD. While PPP is not a great guide to the appropriate level of the exchange rate in many currencies, at least not in the short run, performance relative to PPP is nevertheless a good starting benchmark, especially in developed markets. In the long run, currencies do move with prices – i.e. it is the real level of the currency that matters – and in recent years relatively high inflation in the UK means the appropriate value of GBP is lower than it used to be. The chart shows GBP/USD relative to PPP over the last 20 years, and it is notable that PPP has dropped from 1.60 to 1.30 in the last 10 years. GBP/USD is currently around 15 figures above PPP, compared to an average of 11 figures in the last 20 years. That doesn’t look hugely out of line, but you have to take into account the fact that the US itself is very strong against most major currencies by historic standards. Add to that the fact that the US still looks much the more likely to be raising rates this year, has smaller budget and current account deficits (as a % of GDP), and terms of trade have moved in the USD’s favour with the decline in the oil price (even though GBP is less of a petrocurrency than it once was) and the case for GBP trading above 1.40 seems hard to make longer term, whatever the referendum result.

But it is EUR/GBP where the story is more dramatic. The chart below shows that EUR/GBP PPP has gone form 0.75 10 years ago to around 0.95 now. GBP was further above PPP in 2015 than it has been at any time in the history of the EUR. Now, many will feel that the problems of the Eurozone justify a big premium in GBP. Fair enough up to a point. But the UK’s outperformance of the Eurozone since the crisis has been built on a bigger budget deficit and a record current account deficit. A weak Eurozone will make it difficult for the UK to grow. And if the UK votes to Remain the problems of the Eurozone will remain the UK’s problems just as they are now. Paradoxically, it would be easier to argue for a big premium for GBP if the UK voted “Leave”. At least then there would be some case for arguing that he UK could disengage from a sclerotic Europe (although in practice that will always be difficult). If the UK votes to remain, greater rather than less integration argues for less rather than more divergence. In fact, Q1 saw Eurozone growth outpace the UK. I doubt this will continue in Q2, but the relative performances are nevertheless likely to be less divergent going forward.

So while the short term focus on the polls and the vote itself dominate and GBP is likely to gain a little more ground into and out of the poll on a “Remain” vote, I would see such an outcome as a big long term selling opportunity for GBP against the EUR after the initial knee jerk GBP gain to 0.75 or so. A normalisation of EUR/GBP would become all the more likely, especially since the UK will likely suffer some political instability as Conservative party infighting continues after the vote. EUR/USD and particularly EUR/JPY are also likely to gain, as the EUR has suffered from concerns about the impact a “Leave” vote might have on Eurozone stability, and global risk appetite has also been damaged and is likely to recover, at least initially.

If there is a vote to Leave these pairs will move in the opposite direction, and the impact on the EUR may be nearly as bad as the impact on GBP. Certainly I would expect both to fall against the USD and JPY.

In summary, GBP is a sell on the news, against the EUR on a Remain vote, after the initial GBP rally,  and against the USD on a Leave vote. But EUR/GBP volatility looks too high in the short to medium term, as the fates of the EUR and GBP are likely to be similar whatever the outcome. There may consequently be better value for option players in buying EUR/USD or EUR/JPY options rather than GBP.

 

eurgbpppp

gbpusdppp

 

 

GBP entering Wile E Coyote territory

coyote

 

The GBP focus has been almost entirely on the EU referendum in recent weeks, and this has meant that the steady movement of the polls in favour of the “Remain” camp” has pushed GBP steadily – or sometimes rapidly – higher, helped by still generally short positioning. It will be hard for the market to take notice of anything other than the EU referendum until the vote on June 23, but it does seem as if the focus on this one issue has pushed GBP to levels that look out of line with fundamentals.

The simple metric of the spread between GBP and USD yields worked well until a few weeks ago as a guide to the appropriate level of GBP. But as the US data have improved slightly, global risk appetite has also recovered a touch, and the Fed have indicated that a June rate hike is very possible, US yields have risen and the spread has moved in favour of the USD. At the same time, the UK MPC now seems less convinced that the next move in rates will be up, as the evidence mounts of a slowdown in the economy, which may or may not be related to the referendum. However, GBP/USD hasn’t reacted as usual as short positioning has been unwound in response to the polls, but now there looks to be a gap between the usual yield spread relationship and the currency.

gbpusd

Of course, currency deviations from yield spread correlations are hardly unusual, and can often persist, but usually when there are good structural reasons. For instance, the recovery in the EUR this year has flouted the usual yield spread relationships, but the big Eurozone current account surplus and the low EUR valuation provide some justification for this. There is less case for this with GBP which is still not cheap at current levels and has no current account support – quite the opposite.

For now, it is still hard to see a major turn lower in GBP, as the focus on the polls is still complete and confidence in a “Remain” victory is still increasing. Even so, the 80% probability of a “Remain” victory now priced in will be hard to exceed by much ahead of the polls, and there is still a danger of a swing towards “Leave”. There is now purdah on civil service support for the government “Remain” campaign, so we won’t be seeing any more government produced statistics in favour of the “Remain” case. It looks as if the polls are at best a balanced risk for GBP.

This suggests to me that GBP is vulnerable here. Even if we get a “Remain” victory the fundamentals don’t suggest any case for GBP strength. Yield spreads as shown above are in the USD’s favour, and although this is not the case with EUR/GBP, the high GBP valuation and big UK current account deficit limit the scope for GBP gains against the EUR. There is no particular reason for economic optimism based on the UK data. There may of course by a knee jerk positive reaction to a “Remain” vote, but there is unlikely to be any early evidence that a vote for “Remain” has helped the economy, and there may well be political fallout to deal with related to the split in the Conservative Party that has become more obvious as the referendum campaign has gone on. So rather like Wile E Coyote in the picture above, the market should soon realise that there is nothing supporting GBP strength once the good poll news has gone, and a big drop may well result.

 

Time approaching to sell GBP again

Three factors have combined to create a GBP recovery in recent weeks.

  1. Brexit sentiment has moved in favour of “Remain”.
  2. Positioning was extremely short GBP and has been squeezed
  3. Global risk sentiment has improved.

However, going forward, the scope for generalised GBP gains is now severely diminished. It should not be forgotten that he case for GBP weakness was not based entirely, or even primarily, on Brexit, but on the combination of overvaluation, declining growth outperformance, and a severe current account deficit problem. While GBP weakness in Q1 did reduce the overvaluation issue, it didn’t eliminate it, and after the recent recovery GBP still looks overvalued. Sluggish growth and a big current account deficit remain an issue.

Of the three factors that have helped GBP to recover, the improvement in the fortunes of “Remain” may be the most important, but has probably gone as far as it can. The FT poll of polls below illustrates that the recent uptick in the fortunes of Remain isn’t decisive, and the movement in the bookies’ odds to about 75% in favour of Remain looks like an overrreacction. There is a lot of water to flow under the Brexit bridge yet, and the Scottish referendum underlined the risk of a late swing. Even if Remain stays ahead, I don’t see the Bookies’ odds improving much from here, suggesting risks are on the GBP downside.

While the CFTC data don’t, as of last Tuesday, show any real reduction in GBP shorts, GBP/USD was below 1.44 at that point and I suspect there has now been a significant reduction in short positioning, though probably not a complete reduction. Option positioning is obviously still largely extant, but with strikes generally well below here, the tendency now will be for GBP moves down to be much more amplified that GBP moves up.

The improvement in global risk sentiment has helped GBP, and I don’t expect this to reverse, but expect GBP correlation with risk to fade. The recovery in commodity prices and producers may have helped GBP via the heavy weight of commodity companies in FTSE, but any further equity strength seems likely to be more broad based. I continue to see more value in the Eurozone.

Practically, I would look for a dip to round 0.7680 to buy EUR/GBP. For now, with Q1 US GDP likely to be quite weak, I would not favour the USD, at least until that GDP number is out of the way (released tomorrow Thursday 28th). The Atlanta Fed model is currently looking for 0.4% (annualised, so 0.1% in UK money) and the market expects 0.7%. However, anything above 1.48 would represent value to sell GBPUSD.

brexitpolls

Bias at the Bank?

First of all, let me declare my own view on Brexit, in case anyone thinks what follows represents my own bias (which it may do but I’ll be up front about it). I am voting to stay in the EU, but as much for political/emotional as economic reasons.

Having said that, I believe Carney was showing bias in his positive view of the EU at the Treasury Select Committee hearing yesterday. One reason was presented by Jacob Rees-Mogg, who questioned his statistical arguments as being speculative, and I think that is right, as even Carney admitted that many of the points arguing that the EU had helped boost capital inflows and growth were “arguable”.

But even if that is wrong and you can make a strong statistical argument for membership of the EU having boosted growth and investment in the past, there is no guarantee that that will be the case in the future. Past performance, as Mr Carney should know if he reads the small print to investment advice, is not necessarily a guide to the future. The EU now is different to the EU in the past. Whether being a member is positive for growth and investment will depend to some extent on the arrangements Britain makes with the EU but also on the EU itself and whether it can shake off its persistent economic malaise of recent years . I would agree with the “Remain” campaign that the benefits from leaving are currently pretty nebulous in terms of the things that we would no longer have to do to comply with EU law as it stands, but the terms in the future could change and “ever closer union” could mean an increasing EU straitjacket on the UK.

Now Mr Carney would no doubt argue that he was making no claims for the future but rather just producing the evidence available. Well, yes, but the choice to do so is in itself a decision. Bias is about the questions you ask as well as the answers you give. If you ask the right questions you know you will get the answers you want.

To be fair to Mr Carney, he did say that the decision on Brexit was not purely an economic one, though conveniently that statement justified him providing a pro-EU view with the economic analysis and still being able to claim he wasn’t taking a position on Brexit.

Carney also said that he had not discussed what he was going to say with David Cameron. But since it is part of the Bank’s remit to support the government’s economic policy and maintain financial stability a pro-EU view is almost prescribed. There is little doubt that Brexit would create uncertainties in the short term, even if the impact on markets is more unpredictable than most claim, and the short term could turn out to be quite short.

So in this case, I agree with Jacob Rees-Mogg. It would have been better for Carney to have been far more scrupulously neutral. Not that many voters probably care much what he thinks. After all, while the previous BoE governor Lord King has also said he is not expressing a view on Brexit, his recent comments have been very negative about the Eurozone and could be seen to favour the “Leave” camp, even though he makes it clear that Britain is inextricably linked to the EU regardless of the decision. And while Lord King isn’t everyone’s cup of tea, he will at least still be living here after the referendum, and is  deeply rooted in the UK and has also experienced the whole period of EU membership, the ERM debacle, the financial crisis, etc., and is not beholden to any government or political party. I would suggest his views consequently carry rather more natural weight.

 

GBP weakness just beginning

There is certainly some risk premium in GBP related to concerns about Brexit, but it’s hard to see why this will disappear. Given that the market is still betting on a 65-70% chance that the referendum will produce a vote to stay,  based on the betting exchanges, it is hard to see the risk premium even diminishing much in the run up to the vote. If the Scottish referendum vote is anything to go by, the full risks may not be priced until quite close to the poll, which is now set for June 23. Of course, there is some GBP weakness related to heavy buying of out of the money put options, which we can see in the big skew in the options market, but these are also unlikely to be unwound anytime soon. Indeed, if anything the risk is surely that the odds of Brexit move closer to 50-50 as we approach the referendum, increasing the pressure on GBP. Personally I expect the UK will vote to stay in, but this is unlikely to be felt with any real confidence until much nearer the vote (or possibly not until after it). Incidentally, Brexit concerns should probably be best expressed by short GBP/USD or GBP/JPY as Brexit is bad for the EUR as well as GBP (albeit not as bad).

So Brexit risks still look to be to the downside for now. How about other factors? Many would argue that the relative strength of the UK economy is still a potential GBP positive, and that the focus on Brexit has only temporarily suspended the market’s demand for GBP based on a strong economy and relatively attractive interest rates (at least relative to the Eurozone). However, there are several problems with this view.

First of all, spreads are not that attractive. Sure, it looks like Brexit has created some risk premium, but 2 year spreads (swaps) have narrowed from 1.1% to 0.9% this year. The latest MPC testimony to the Treasury select committee suggested a split committee, but one where the possibility of a rates cut and/or more QE was being considered by at least 3 members (Carney, Vlieghe, Haldane) if the economy were to take a turn for the worse. Given the zero bound is not yet a factor for the UK curve, there is a lot of potential downside for UK yields in this scenario. Even so, I wouldn’t base a negative GBP view on declining yield spreads. The UK data is still reasonably robust, albeit with some weak patches, and I feel the evidence of global weakness has been somewhat overstated, with emerging markets looking much more pressured than developed markets. This may change, but for now I wouldn’t get overexcited about the scope for a UK rate cut, and the UK curve is probably pricing too dovish a view. Nevertheless, until global sentiment improves, a return of the prospect of UK rate hikes can’t be seen as a supportive factor for GBP.

But even if we take a positive view of the prospects for the UK economy and interest rates, and even if Brexit concerns don’t increase, I would argue that the upside for GBP is very limited because of the two problems of valuation and the UK current account deficit (and related budget deficit). While valuation is rarely a big factor for currencies in the short term, it is significant at extremes and the chart below of the GBP real effective exchange rate underlines that the pound is still at high levels even after the latest decline. The real trade-weighted index is still only around 10% off 2008 highs, and some 20% above 2009 lows, while in nominal terms the story is the other way around (20% off the highs, 10% off the lows), disguising the true extent of GBP strength.

gbppic

Source: BIS

But the other main consideration is the fundamental issue of the UK current account and its significance for GBP. Like valuation, the current account tends not to be a focus in developed countries in the short run, but over the long run there is  strong correlation between the current account position and a currency’s valuation. Countries with big current account surpluses tend to have currencies that trade well above Purchasing Power Parity (PPP), while those with big deficits have currencies that tend to trade below PPP. The big deterioration in the UK current account in recent years suggests it should be trading further below PPP. According to the OECD, GBP/USD PPP is 1.42 based on GDP. Given that the US has a much healthier current account and higher yields this should be seen as a ceiling, even assuming no Brexit risk. The OECD estimate of EUR/GBP PPP for GDP is a more dramatic 0.92! Given that the Eurozone is running a current account surplus of 3% of GDP while the UK has a deficit of 6% of GDP this suggests GBP is extremely expensive against the EUR from a longer term perspective. Relatively high UK yields  justify some GBP strength but only extremely negative EUR sentiment has kept GBP strong in recent years. The other implication of the relative current account positions is that while relatively strong UK growth has made UK yields more attractive, it has also sucked in imports and means the UK has a growing current account gap to finance. Strong growth funded by borrowing from abroad is not the formula for a strong currency longer term.

The conclusion is that even if the UK avoids Brexit and even if next UK move in rates is up, the still high level of the pound suggests there is more GBP weakness to come, possibly in the shape of a traditional UK balance of payments crisis.  More likely, the tightening of UK fiscal policy will restrict the current account deterioration and preclude the need for higher interest rates for some time, but this will not mean a GBP recovery, only a slower decline.