The EU Will Succumb

Said Boris, the time has now come
To exit ‘neath Parliament’s thumb
I spoke to the Queen
She sees what I mean
And soon the EU will succumb

Prorogue: verb
1: defer, postpone
2: to terminate a session of (something, such as a British parliament) by royal prerogative

I thought it would be useful to offer a definition of this word as it will certainly be in the news for the next few weeks. In fact, every year there is a prorogation of parliament in September as MP’s, after returning from their summer holidays need time to prepare for and attend their party conferences. The idea is that parliament is officially closed, but it has not been dissolved, thus there is no requirement for a new election.

What makes things different this year, of course, is Brexit. Boris has asked the queen to prorogate parliament for one additional week, until October 14 when she is slated to give the Queen’s Speech, which traditionally opens the new session. If this request is granted, the result is that parliament will not be in session, and therefore unable to create legislation to block a no-deal Brexit, until just two weeks before the deadline. Naturally MP’s are up in arms over the decision as those seeking to block a no-deal Brexit suddenly find themselves with fewer options. Personally, however, I think it is a brilliant move to put more pressure on the EU. Undoubtedly the EU is counting on parliament to override Boris’s stated intention of leaving with no deal if one cannot be found by the current deadline. Suddenly, this avenue has been closed off and the EU is now that much closer to feeling significant pain for which they have not planned.

To highlight the situation, the German Institute for Economic Research, or DIW, has just put forth its latest forecast for Q3 GDP growth in Germany at -0.2%. If correct, and they have an excellent track record, that means the last four quarters of GDP in Germany will have been -0.1%, 0.0%, -0.1% -0.2%. I don’t know about you, but that looks like a recession to me. With that as the backdrop, a hard Brexit, where German autos would suddenly be subject to a 10% tariff in the UK thus resulting in reduced demand in Germany’s third largest market, will be very tough to swallow. While there are those who claim Boris would be irresponsible to allow the damage to the UK economy by leaving with no deal, it is just as easy to describe Chancellor Merkel as irresponsible to not drive forward a deal rather than subject Germany to further, unnecessary pain. As I said, I think it is a brilliant move on PM Johnson’s part.

Of course, FX traders being what they are, see only the trees, not the forest, and so the pound has sold off sharply this morning, at one point trading lower by 1.1% although as I type it is down 0.7% at 1.2200. Nothing has changed regarding the pound’s reliance on the Brexit outcome and a hard Brexit will almost certainly result in a sharp, short-term decline, likely toward 1.10, while a deal will result in a sharp rebound, possibly back to the 1.35 level. My money is on a last minute deal and a rebound.

Away from Brexit, the other really big story is the more definitive instance of the 2yr-10yr yield curve inversion. Prior to yesterday’s session, that inversion had been, at most, 1bp and only for a few hours intraday. However, last night we closed at a 5bp inversion and we are watching overall yields fall sharply. This morning 30yr Treasury yields have reached new historic lows at 1.92%. Bunds are also seeing significant demand with the 10yr there seeing its yield fall to -0.72%, also a new historic low. Arguably, yesterday’s late equity market decline was a response to the steeper inversion and if the inversion goes further, I imagine equity markets will decline as well.

With risk being set aside across most markets, the dollar continues to be a main beneficiary. Looking at the dollar’s performance this month, only three currencies have outperformed the greenback, the yen (+1.5%), the Swiss franc (+1.0%) and the pound (+0.7%). The first two are clearly haven assets, while the pound happens to be slightly higher based on the fluctuations in thought around the Brexit outcome. Otherwise, the dollar reigns supreme against both G10 and EMG currencies. In fairness, though, the euro is essentially unchanged on the month as market participants are still trying to decide whether it exhibits haven characteristics and can be a substitute for the dollar, or whether it should be considered part of the masses. Given the interest rate structure in the Eurozone, my view remains weakness ahead, but certainly that is not a given.

An interesting aside has been the beginnings of a discussion by pundits and policymakers that the dollar’s strength is hurting other nations as well, and that a concerted effort to push it down may be appropriate. Consider that there are trillions of outstanding USD debt issued by countries and companies throughout the emerging markets and as the dollar rises, their ability to repay and refinance that debt is made increasingly difficult. Large scale debt defaults will not be a boon for global economic activity and so one solution is to drive the dollar lower and prevent those defaults from occurring. While it is still early days, listen closely as this idea gains credence, because if it does it will certainly help slow the dollar’s rise.

As to the rest of today’s session, there is no US data today, although tomorrow starts a run of important info. We do, however, hear from two Fed speakers, Daly and Barkin, the former being quite the dove while the latter is more middle-of-the-road. And we cannot forget about the Italian political negotiations as 5-Star and the Democratic Party (funnily enough it is a center right party in Italy) try to agree on the terms of a government to prevent new elections. Trade? Yeah, it’s still there but there is nothing new on that front to move things. In the end, I see no reason for the dollar to retreat yet.

Good luck