In England and Scotland and Wales
Young Boris has wind at his sails
A thumping great win
To Labour’s chagrin
Has put Brexit back on the rails
As well, from the US, the news
Is bears need start singing the blues
The trade deal is done
At least for phase one
Thus more risk, investors did choose
An historic victory for PM Boris Johnson yesterday has heralded a new beginning for the UK. Historic in the sense that it is the largest majority in Parliament for either party since Margret Thatcher’s second term, and historic in the sense that the Labour party won the fewest seats since 1935. One can only conclude that Jeremy Corbyn’s vision of renationalization of industry and high taxes was not the direction in which the UK wants to head. Perhaps the only concern is the Scottish National Party winning 49 of the 58 seats available and will now be itching to rerun the Scottish independence referendum. But that is an issue for another day, and today is all about a huge relief rally in equities as the threat of a hard Brexit essentially disappears, while the pound has also benefitted tremendously, rising 1.7% from yesterday’s closing level and having traded almost a full percent higher than that in the early aftermath of the results. So here we are this morning at 1.3390, right at my forecast for the initial move in the event of a Johnson victory. The question of course, is where do we go from here?
Before I answer, I must also mention the other risk positive story, about which I’m sure you are already aware, the news that President Trump has signed off on terms of a phase one trade deal with China. The details thus far released indicate China has promised to buy $50 billion of agricultural products from the US, and will be more vigilant in protection of IP rights, while the US is set to reduce the tariff rates already imposed and delay, indefinitely, the tariffs that were due to come into effect this Sunday. Not surprisingly, equity markets around the world rallied sharply on this news as well while haven investments like Treasuries, Bunds and the yen (and the dollar) have all fallen.
So everyone is feeling good this morning and with good reason, as two of the major political uncertainties that have been hanging over the market have been resolved. With this in mind, we can now try to answer the question of what’s next in the FX markets.
History has shown that while macroeconomic factors have some impact on the relative value of currencies, that impact is driven by the corresponding interest rates in each nation. So a nation that has strong economic growth and relatively tighter monetary policy is likely to see a strong currency while the opposite is also true. Now this correlation is hardly perfect, and financial theory cannot be completely ignored regarding a country’s fiscal balances (current account, trade and budget), where deficits tend to lead to a weaker currency, at least in theory, and surpluses the opposite. Obviously, one need only look at the dollar these days to recognize that despite the US’s significant negative fiscal position, the dollar remains relatively quite strong.
But ever since the financial crisis, there has been another part of monetary policy that has had a significant impact on the FX market, namely QE. As I’ve written before, when the US was implementing QE’s 1, 2 and 3, the dollar fell markedly each time, by 22%, 25% and 17% over a period of 9 months, 11 months and 22 months respectively. Clearly that pattern demonstrates the law of diminishing returns, where a particular action has a weaker and weaker effect the more frequently it is used. Of course, in each of these cases, the Fed funds rate was at 0.00%, so QE was the only tool in the toolbox. This brings us to the current situation; positive interest rates but the beginning of QE4. I know that none of us think 1.5% is a robust return on our savings, but remember, US interest rates are the highest in the G10, by a lot. In addition, the economy seems to be doing pretty well with GDP ticking over above 2.0%, Unemployment at 50 year lows and wage gains solidly at 3.0% or higher. Equity markets in the US make new highs on a regular basis and measured inflation is running right around 2.0%. And yet…the Fed is clearly looking at QE despite all their protestations. Buying $60 billion per month of T-bills with the newly stated option of extending those purchases to coupons is clearly expanding the balance sheet and driving risk accumulation further. And that is QE!
So with the knowledge that the Fed is engaged in QE4, and the history that shows the dollar has fallen pretty significantly during each previous QE policy, my view is that we are about to embark on a reasonable weakening of the US dollar for the next year or so. Now, clearly the initial conditions this time are different, with positive growth and interest rates, but while that will likely limit the dollar’s decline to some extent, it won’t prevent it. If pressed, I would say that we are likely to see the dollar fall by 10% or so over the next 12-18 months. And that is regardless of the outcome of the US elections next year. In the event that we were to see a President Warren or President Sanders, I think the dollar would suffer far more aggressively, but right now, removing the effect of the election still points to a slow decline in the buck. So for receivables hedgers, it is likely to be a situation where patience is a virtue.
Turning to the data story, last night we saw the Japanese Tankan report fall to 0, below expectations of 3 and down from its previous reading of 5. But the yen’s 0.35% decline overnight has more to do with risk appetite than that particular number. However, I’m sure PM Abe and BOJ Governor Kuroda are not thrilled with the implications for the economy. Otherwise, there has been precious little else of note released leaving us to ponder this morning’s Retail Sales data (exp 0.5%, 0.4% ex Autos) and wait to hear pearls of wisdom from NY Fed President Williams at 11:00. Of course, given the fact the Fed just finished meeting and there appears very little uncertainty over their immediate future course, my guess is the only thing he can try to defend is ‘not QE’ and how they are on top of the repo situation. But today is a risk on day, so while we may not extend these movements much further, I feel we are likely to maintain the gains vs. the dollar across the board.
In a final note, this will be the last poetry until January as I will be on vacation and then will return with my prognostications for 2020 to start things off.
Good luck, good weekend and happy holidays to all