Brexit and the Pound: Plenty of Downside Left

So where are we now? It seems to me that “terrible” is not just the most likely scenario, it’s not even the worst possible scenario any more. In my view, an interim government under Labour with Jeremy Corbyn at its helm represents the worst of all possible worlds for GBP: economic dogmatism that will frighten markets coupled with a pro-Leave bias. Which is not to say that I’m any great fan of the incumbent Conservative government either, except insofar as I’m an American citizen and so grateful for any group of politicians that make our Congress seem reasonable and well-functioning by comparison.

But let’s put politics aside and look at the economics. Where is the pound nowadays? The simplest way to value the currency is relative to its past value. For this exercise, we use the real effective exchange rate (REER): the value of the currency against the country’s major trading partners, adjusted for inflation. It’s important because trade imbalances are one of the major factors moving currencies over the longer term.

On this metric, back in March, the pound was just 1.2% undervalued against a basket of currencies of the major economies. Currently, it’s about 7.1% undervalued – still not at the 10% undervalued line that has sometimes (but not always) been a barrier in the past. That means even under normal circumstances, it can fall further. And as you can see, in extraordinary circumstances, such as the Global Financial Crisis in 2008/09, that 10% line is no barrier to GBP depreciation. (Last time I used the IMF’s calculation for the GBP REER, but this time I’m using the BIS’, which is updated more frequently.)

The more theoretical way of valuing the pound would be with purchasing power parity. That’s as close a metric as we can get in forex analysis to seeing whether a currency is “fairly valued.” Looked at this way, the pound is still relatively expensive against the euro. According to the OECD’s way of calculating PPP – taking a large basket of goods and services and pricing them in different countries — the pound is 12.7% undervalued vs USD but still 8.1% overvalued vs EUR! This compares with -8.7% and +11.%, respectively, back in March. And considering that the EU is Britain’s largest trading partner (51.6% of total trade) vs 10.6% to the US and 7.6% to China, the two dominant USD trading partners, it’s clear that the pound’s value relative to EUR is the more important of the two prices. It’s got far to go before it hits up against the 20% line that has in the past provided some resistance (as that’s about the level where the currency starts to impact trade flows).

For GBP/USD to hit the -20% line, the pair would have to be at 1.14. For EUR/GBP to hit that level, the pair would have to be 1.20 (implying GBP/USD at 1.08, assuming EUR/USD stays at its current rate). It looks like the long-awaited “pound parity party” is coming up!

This analysis so far builds on what I said last time: although the pound has fallen considerably since before the Brexit vote, that doesn’t mean it’s cheap yet. It can still fall further.

Back in March, I made the balance of payments argument for why sterling should fall further: that after Brexit, the current account deficit is likely to widen further (because exports will be held up) while the financial account surplus is likely to diminish (as both direct investment and portfolio investment turns into an outflow). That argument still holds. Now I’d like to focus on the monetary reasons why the pound is likely to weaken, namely: the market isn’t at all discounting the Bank of England’s likely reaction to Brexit.

Basically, the market sees little chance of any significant Bank of England easing – it’s only pricing in a 50% chance of even one rate cut by June of next year.

The market is implying that over the next year, the BoE may cut rates about as much as the ECB – which already has negative rates – and the Bank of Japan – which hasn’t had significant inflation for about two decades.

Over the longer term, it’s expected to cut rates very little – even less than the Bank of Japan, somehow.

The small amount of rate cuts that are priced in probably reflect the fact that Bank’s policy rate may be positive, but it still isn’t that high in international terms, neither in nominal nor in real terms, even if it is positive.

However, that comparison fails to take into account the impact of the quantitative easing that other central banks undertook. If we adjust for that, we get what are called shadow policy rates.* These show much better just how tight UK monetary policy is relative to the urozone or Japan. It’s nearly the same as in the US, where rates had been lifted from almost the same starting point (effectively) nine times before coming down once (the graph only has month-end data and so doesn’t encompass the Fed’s rate cut this week).

In other words, UK monetary policy is still very tight and yet the market is only pricing in the minimum amount of loosening – about as much as central banks that are already well into negative territory for their policy rates. Is this reasonable? It was back before Brexit, when the Bank of England was in the process of “normalizing” interest rates (on the assumption that “normal” was still the way the world worked before September 2008). And that’s basically what the Monetary Policy Committee (MPC) would have us believe. Following Thursday’s meeting, they repeated their usual comments that if it looks like Brexit will go smoothly, they would raise rates “at a gradual pace and to a limited extent.” Even in the case of a no-deal Brexit, the Bank’s response “would not be automatic and could be in either direction.”

Does anyone believe that? Will the one rate cut that’s not even fully priced in be enough to fight the biggest shock to the UK economy since James Callaghan had to borrow money from the IMF in 1976? Of supermarket shelves empty while lambs that were destined for foreign markets are being slaughtered by the thousands? Central bankers may be dedicated to fighting inflation but they also have to be aware of what the population is facing. Besides, even the BoE itself said Thursday that if there was “entrenched uncertainty” over Brexit, “domestically generated inflationary pressure would be reduced.” That gives no reason to expect a hike in rates any time soon – and a lot of reasons to expect the Bank of England to join the world’s rate-cutting cycle.

I think the market is being too, too sanguine about the likely impact of Brexit on the UK economy and the Bank of England’s likely response. The rational course in case of a downturn would be for the Bank to cut rates and let sterling act as a “shock absorber” in troubled times. I still see plenty of downside to the pound as the prospect of below-consensus interest rates add another reason to sell on top of impending economic and political chaos.

This article was written by Investment Strategy Contributor Marshall Gittler that shared his exclusive insights in an in-depth Brexit analysis powered by BDSwiss


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Gold, GBP and Inflation Expectations Grabbing My Attention

I touched on this in the chart of the day, but with the world’s central banks watching inflation and inflation expectations incredibly closely, it makes sense macro traders do too.

That is what we saw in US trade, and the wash-up has been a renewed bid in the bond markets, taking the pool of negative-yielding government bonds $239m higher on the day, to currently sit at $12.8t. I’ve looked at this in relation to gold below, and while a two-year regression shows the correlation between the two variables is not overly significant, it’s fair to say there is a shared theme here.

Bloomberg

Rates pricing moving towards 50bp of cuts

We can also look at the US rates market overnight, where we can now see a 34% chance of a 50bp cut, and while I should probably apologies for persistently banging this US-centric drum, there is no doubt the 25bp-50bp debate is the big talking point out there right now. If we see US 5-year inflation expectations heading back towards 1.90%, then it markedly increases the possibility of a 50bp cut, despite certain better US data points, and if this materialises, watch the markets fire up.

In fact, we may get a touch more clarity tonight, where at 04:15aest NY Fed President John Williams speaks on monetary policy. Williams is a core voting member within the Fed, so any hints that he is genuinely worried about the external picture and vulnerabilities in the global economy and we may see the interest rate markets move to price a 50% chance of a 50bp. This is an event risk for traders.

With the global growth story in mind, it segways nicely into today’s Bank of Korea meeting, where we saw an out-of-consensus rate cut to 1.5%. Some will point to tensions with Japan behind the easing, but some see the weakness in Korean exports as a leading guide on the external demand thematic, and we can see how this correlates with the MSCI All country index.

Gold to $1500?

Going back to the Williams speech, should we get clues he’s steering to 50bp, which seems unlikely, but should it play out, then in this scenario, gold (XAUUSD) builds on the move we saw yesterday, and we head onwards and upwards towards $1500.

Aussie factors weighing on XAUAUD

In fact, if we look at gold in EUR terms (XAUEUR), we can see the price here has broken to new highs, with an outside period seen in yesterday’s candle. AUD-denominated gold (XAUAUD) has yet to kick higher and hasn’t benefited from the modest AUD strength seen in the wake of the Aussie job’s numbers. Which, when digging into the numbers are a small positive given we saw strong full-time jobs creation and the participation rate was slightly better. The NAB business confidence report also improved.

We always follow price as a voting mechanism to understand why people are buying and why they are selling where they are. But there is a raft of different ways we can assess sentiment towards any market and many in the institutional space like to look at the options world as a guide. I am happy to provide clients information on options skews if it helps, but if I look at the difference (or the ‘skew’) of call vs put implied volatility, we see this sits at an all-time high of 4.

The higher the demand for call options, which give us the right to buy, the higher the implied volatility. So, when the skew is so heavily favoured towards structures that give us the right to buy should the market price be above the strike price, you can see exactly where options traders feel the balance of risk lies for the yellow metal.

Pairs trading – if you’re not doing it and interested let me know

While the bulk of our flow has been in gold and GBP, we are seeing good interest in US equity indices, and the flow is two-way. There is a battle underway in the S&P 500, and the earnings rolling in are not helping to any great degree.

One way of trading an index is through ‘pairs’ trading. Take a look at the S&P 500 (US500)/Russell 2000 (US2000) ratio. Ratio analysis is just one way to look at this, but it gives a guide on how the markets are interacting with each other and the outperformance. In this case, the US500 is the numerator, so when this index is going up, we see the US500 outperforming the US2000.

Being long the US500 and short the US2000 has been working so well that the ratio sits at the highest levels since 2009. If this breaks out convincingly, I will be looking at exposures here.

The math is simple

When looking at pair’s trades, it is key that both legs of the trade have the same notional exposures, or at least as close as possible. So, we, therefore, start with a USD amount, let’s say $10,000 and then divide this by the index level at the time. So, with the US500 trading at 2984 and US2000 at 1550, I would buy 3.4 contracts of US500 ($10,000/2984) and sell 6.5 contracts of US5000. Or, vice versa if you feel the US2000 will outperform,

Trading pairs (or long/short) strategies are lower beta, meaning they don’t tend to have sizeable P&L swings and can be a great way to really hone in on one theme and exploit it.

Anyhow, I find it an interesting way to trade markets and happy to offer more guidance if clients are interested.

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Chris Weston, Head of Research at Pepperstone.

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Three promising setups on pairs without the USD: NZDJPY, EURAUD and GBPCAD

Today on the video, we do have two occasions for the future which may be good for using pending orders and one, which is good right here, right now. The first setup is on the NZDJPY, which is on the long-term horizontal support around the 75.7 support. The price closing below the opening from today will be a strong sell signal.

The next one is the EURAUD, which is going down despite a good occasion for a bullish reversal. Buyers had it all: up trendline, horizontal support a flag and a possible iH&S. As for now, it looks like they will not use it and the price may go down. For a sell signal, we need to see the breakout of the green area.

Next one is the GBPCAD, which is currently showing the main principle of the Price Action. Broken support becomes a resistance. This resistance is the area around the 1.739 and the 38,2% Fibonacci. This setup has a very good risk to reward ratio so is definitely the one to look at.

This article is written by Tomasz Wisniewski, a senior analyst at Alpari Research & Analysis