All Doom and Gloom

As talks over Brexit resume
The headlines are all doom and gloom
But pound traders seem
To think that the dream
Is real, helping cable to zoom

Once again, the overnight session has been uninspiring, although there seem to be a few conundrums this morning.  The most interesting one is the dichotomy between the pound’s recent performance (+0.2% today, +1.0% this week), and the headlines regarding the difficulty in reaching a Brexit deal.  Time is clearly running short as the two sides get together once again to hash out issues as wide-ranging as access to UK waters for fishing to questions over the application of state aid for companies.  Clearly, there are no easy answers, and in the end, at least one side is going to need to adjust their current views for a deal to be reached.  And arguably, this is a two-week drill, as the details need to be agreed in time for the EU summit, to be held on October 15th, in order to allow enough time for all 27 other EU members to ratify the deal.

The question at hand, though, is what is priced into the market given the pound’s current level of 1.2850.  A quick look at the pound’s price history since the historic vote back in June 2016 shows that the range of trading has been 1.1412 (reached during the initial Covid panic) to 1.5018 (reached in the first minutes after the Brexit vote when the belief was Bremain had won.)  However, if we remove the Covid panic, which was clearly an exogenous event, then the low was 1.1841, reached in October 2016 during the leadership change in the UK.

With this as our framework, it is then worthwhile looking at valuation models, none of which really line up, but perhaps offer some modest insight.  For instance, a PPP valuation based on CPI shows the pound is undervalued by less than 4%, but based on the Big Mac index, Sterling is cheap by 28.5%.  When looking at Effective Exchange rates (REER and NEER), the evidence points to the Big Mac index being a better indicator, with measures for both showing the pound is roughly 24% undervalued.  However, it hardly seems likely that the true value of the pound is near 1.70, which is what those adjustments would imply.  Finally, simply taking a longer term look at the pound’s value (1983-2020) shows that the average price is around 1.5850.  Of course, during all of this time, the UK has been a member of the EU so upon its exit, there will be a significant change in its terms of trade, even if there is a deal.

What conclusions can be drawn from this information?  No matter the backdrop, the pound is in the lowest quartile of its historic price levels, which implies the market is anticipating some bad news.  In the event of a hard Brexit, will the pound trade to new lows, below those seen in 1985?  That seems unlikely.  After all, the UK is not going to sink into the North Sea, it is simply going to change the terms on which it deals with the EU.  Rather, a hard Brexit seems more likely to see a movement toward 1.15-1.20, in my view, as long positions get squeezed and a general gloom settles over the economy, at least initially.  On the other hand, successful negotiations may well see a move toward 1.40-1.45, still undervalued based on some of the indicators, but moving back toward its long-term average.  All in all, I would estimate the market has priced in a two-thirds probability of a hard Brexit, so while further declines are possible, parity with the dollar seems unlikely.  Parity with the euro, however, could well arrive in that scenario.

Turning to the rest of the market, though, shows the entire FX complex appears out of sync with the risk framework.  Equity markets are lower throughout Europe (DAX -0.4%, CAC -0.2%, FTSE 100 -0.5%) after an uninspiring session in Asia (Nikkei +0.1%, Hang Seng -0.85%, Shanghai -0.2%).  US futures are essentially flat, although have spent the bulk of the evening session modestly lower.  Bond prices are a bit firmer this morning, at least in Europe, where Bunds, OATs and Gilts have all seen yields edge 1basis point lower on the day.  Treasury yields, however, are essentially unchanged, still right around 0.65%,

Commodity markets show oil prices softer (WTI -0.65%) but precious metals slightly firmer (Gold +0.4%).  In fact, all metals prices are a bit higher, but agricultural prices are softer.  In other words, signals here are mixed as well.

Finally, the dollar, despite what appears to be a mild risk-off session, is weaker pretty much vs. all its G10 brethren with only the JPY (-0.1%) the outlier.  Arguably, that looks more like a risk-on day than a risk-off one.  The leading gainer in the bloc is AUD (+0.7%) which has been the beneficiary of demand for AGB’s, a slightly higher confidence index reading and a change in view regarding further RBA stimulus by Westpac, one of the big four Australian banks. It should be no surprise that NZD (+0.55%) has followed the Aussie higher, but the rest of the bloc is having a solid day amidst broad-based dollar weakness.

EMG currencies are starting to show more strength at this hour, led by PLN (+1.15%), although gains in MXN (+0.9%), HUF (+0.7%) and CZK (+0.65%) are solid as well.  The zloty has been responding to comments from one of the central bank’s members, Eugeniusz Gatnar, describing near zero interest rates as hurting the economy and calling for normalization by next year.  Meanwhile, MXN seems to be benefitting from an increase in the carry trade, where despite recent volatility, the search for yield is forcing many investors to areas they would not have previously considered.  Overall, the only currencies that have been under pressure remain RUB and TRY as the escalation of fighting between Armenia and Azerbaijan weighs on their sponsors.

On the data front, there was precious little overnight, Tokyo CPI ex Fresh Food fell -0.2%, while European data was all second tier.  This morning we see Case Shiller Home Prices (exp 3.60%) as well as Consumer Confidence (90.0), however, neither of these seem likely to change views.  Of more importance, we have four more Fed speakers, although yesterday’s had little impact.  Arguably, the thing which has the market’s attention is tonight’s first presidential debate, but at this point, it is difficult to determine what type of impact it may have.  Ultimately, a change in the White House is likely to have some significant market implications, with the dollar’s value being clearly impacted.  But it is far too early to discuss this issue.

For today, it appears that the FX market is leading the equity markets, a highly unusual situation, but I expect that we will continue to see modest USD weakness while equity markets edge higher.

Good luck and stay safe
Adf

Despite Cash

In China the stock market sank
Despite cash from its central bank
But elsewhere it seems
The narrative deems
Investors, the Kool-Aid, have drank

So, it can be no surprise that after a one and a half week hiatus, the Chinese equity markets sold off dramatically (Shanghai -7.8%) when they reopened last night. After all, equity markets elsewhere in the world had all been under pressure for the entire time as the novel coronavirus spread seemed to accelerate. Of course, since Chinese markets closed for the Lunar New Year holiday, major global markets in the west had fallen only between 3.5% and 4.0%. But given China is the country whose economy will be most impacted, the ratio doesn’t seem wrong.

What we learned over the weekend, though, is that the acceleration has not yet begun to slow down. The latest data shows over 17,000 infected and over 300 deaths are now attributable to this illness. Most epidemiological models indicate that we have not reached the peak, and that it would not be surprising to see upwards of a quarter of a million cases within the next month or two. Remember too, this assumes that the information coming from China is accurate, which given the global reaction to the situation, may be a big ask. After all, I’m pretty sure President Xi Jinping does not want to be remembered as the leader of China when it unleashed a global pandemic. You can be sure that there will be a lot of finger-pointing in China for the rest of 2020, as some heads will need to roll in order to placate the masses, or at least to placate Xi.

But in what has been a classic case of ‘sell the rumor, buy the news’, equity markets in the rest of the world seem to have gotten over their collective fears as we see modest strength throughout Europe (DAX +0.2%, CAC +0.2% FTSE +0.4%) and US futures are all pointing higher as well. So at this point in time, it appears that the market’s modest correction last week is seen as sufficient to adjust for what will certainly be weaker growth globally, at least in Q1 2020. Something tells me that there is further repricing to be seen, but for now, the default belief is that the Fed and other central banks will do “whatever it takes” as Signor Draghi once said, to prevent an equity market collapse. And that means that selling risk would be a mistake.

With that as prelude, let’s turn our attention to what is happening away from the virus. The biggest FX mover overnight has been the pound, which has fallen 1.1% after tough talk from both PM Boris Johnson and EU Brexit negotiator Michel Barnier. The market’s concern seems to be that there will be no agreement reached and thus come December, we will have a Brexit redux. I am strongly in the camp that this is just posturing and that come June, when the decision for an extension must be made, it will be done under the guise of technical aspects, and that a deal will be reached. Neither side can afford to not reach a deal. In fact, one of the key discussion points in Europe this morning is the fact that the EU now has a €6 billion hole in its budget and there is nobody able to fill the gap.

On the data front, Eurozone Manufacturing PMI data was modestly better than forecast, with the bloc-wide number at 47.9, still contractionary, but Italy, France and Germany all edging higher by a tenth or two. However, despite the modestly better data and the modest uptick in equity markets, the single currency is under some pressure this morning, down 0.25%, as the market adjusts its outlook for Fed activity. It remains pretty clear that the ECB is already doing everything it can, so the question becomes will the Fed ease more aggressively as we go forward, especially if we start to see weaker data on the back of the coronavirus situation. Friday’s market activity saw futures traders reprice their expectations for Fed rate cuts, with the first cut now priced for July and a second for December. And that rate change was what undermined the dollar during Friday’s session, as it suddenly appeared that the US would be stepping on the monetary accelerator. In fairness, if the quarantine in China continues through the end of Q1, a quick Fed rate cut seems pretty likely. We shall see how things evolve. However, this morning sees a bit less fear all over, and so less need for Fed action.

The other main mover in the G10 was NOK (-0.7%), which given how much oil prices have suffered, seems quite reasonable. There is a story that Chinese oil demand has fallen 20% since the outbreak, as the combination of factory closures and quarantines reducing vehicle traffic has taken its toll. In fact, OPEC is openly discussing a significant production cut to try to rebalance markets, although other than the Saudis, it seems unlikely other producers will join in. But away from those currencies, the G10 space is in observation mode.

In the emerging markets, it should be no surprise that CNY is much weaker, falling 1.1% on-shore (catching up to the offshore CNH) and trading below (dollar above) 7.00. Again, that seems pretty appropriate given the situation, and its future will depend on just how big a hit the economy there takes. Surprisingly, the big winner today is ZAR, which has rebounded 1.0% after Friday’s sharp decline which took the currency through the 15.0 level for the first time since October. In truth, this feels more like a simple reaction to Friday’s movement than to something new. If anything, this morning’s PMI data from South Africa was much worse than expected at 45.2, which would have seemingly undermined the currency, not bolstered it.

On the data front, this week will be quite active as we see the latest payroll data on Friday, and a significant amount of new data between now and then.

Today ISM Manufacturing 48.5
  ISM Prices Paid 51.5
  Construction Spending 0.5%
Tuesday Factory Orders 1.2%
Wednesday ADP Employment 158K
  Trade Balance -$48.2B
  ISM Non-Manufacturing 55.1
Thursday Initial Claims 215K
  Unit Labor Costs 1.2%
  Nonfarm Productivity 1.6%
Friday Nonfarm Payrolls 160K
  Private Payrolls 150K
  Manufacturing Payrolls -4K
  Unemployment Rate 3.5%
  Average Hourly Earnings 0.3% (3.0% Y/Y)
  Average Weekly Hours 34.3
  Participation Rate 63.2%
  Consumer Credit $15.0B

Source: Bloomberg

Obviously, all eyes will be on the payrolls on Friday, although the ISM data will garner a great deal of attention as well. Last Friday’s core PCE data was right on the screws, so the Friday rate movement was all about coronavirus. With the FOMC meeting behind us, we get back to a number of Fed speakers, although this week only brings four. Something tells me there will be a lot of discussion regarding how they will respond to scenarios regarding China and the virus.

In the end, short term price action is going to be all about the virus and its perceived impact on the global economy. Any indication that the outbreak is slowing down will result in an immediate risk grab-a-thon. If it gets worse, look for havens to get bid up quickly.

Good luck
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