Sterling and major currencies have lacked direction in the past five weeks
The Sterling Nominal Effective Exchange Rate (NEER) – a trade-weighted index of Sterling’s exchange rates versus the UK’s main trading partners – fell sharply in early September before recovering some of its losses. Since mid-September it has traded in a narrow range of just 1.9% and is up only 1% from five weeks ago (see Figure 1).
Figure 1: Sterling has struggled for clear direction in the face of a multitude of headwinds and tailwinds
Source: 4X Global Research, Bank of England, investing.com
This is the result of Sterling and the main currencies which make up the Sterling NEER, including the Euro, Japanese Yen and Swiss Franc, being largely unchanged against the US Dollar since mid-September (see Figure 2).
Figure 2: The currencies of the UK’s main trading partners have also been treading water in the past five weeks
Source: 4X Global Research, Bank of England, investing.com
Note: Percentages are weight of currency in Sterling Nominal Effective Exchange Rate (only currencies with a weight greater than 1.5% are included in this chart).
Moreover, daily realized volatility in these currencies has been subdued. Our measure of global volatility – the 10-day standard deviation in the daily percentage change in a weighted basket of US Dollar pairs (using spot closing prices) – has fallen to a one-month low of about 0.37 (see Figure 3). Notably, even volatility in high-yielding emerging market currencies, including the South African Rand, Brazilian Real and Mexican Peso, has collapsed. Sterling volatility is still amongst the highest within developed currencies but has fallen to 0.55 from 0.74 a month ago and is only slightly higher than its 10-year average of 0.48.
Daily moves in Sterling and other major currencies have on the whole been “orderly”, even if intra-day volatility has spiked on occasion. We think that limited price action points to market participants eager to take profit or cut losses in a bid to protect year-to-date gains, particularly as the near-term market outlook remains cloudy at best.
Figure 3: Realized volatility in USD crosses, including GBP/USD, has on the whole fallen in past month
Source: 4X Global Research, BIS, investing.com
Note: Spot/closing price. Global is basket weighted by currency-pair turnover in 2016; currency pairs versus US Dollar are AUD, CAD, CHF, DKK, EUR, GBP, JPY, NOK, NZD, SEK, ARS, BRL, CLP, COP, MXN, CZK, HUF, PLN, RON, RUB, ZAR, TRY, ILS, CNY, IDR, INR, KRW, MYR, PHP, SGD, TWD and THB.
The bottom line is that in recent weeks major currencies have shown remarkably little direction within reasonable ranges or daily volatility despite, or more likely because of the confluence of covid-related, macro, policy and geopolitical developments. These have included the Federal Reserve’s change on 27th August to its dual inflation and employment mandate, ongoing EU-UK trade negotiations now at a critical stage (as we discuss below), the sustained increase in new covid-19 cases in many European countries (including the UK) and re-tightening of national lockdowns, and the European Central Bank’s half-hearted attempts to jawbone the Euro weaker.
Moreover, event risk between now and mid-November – which of course includes US presidential elections – is particularly acute. The lack of FX price action is thus not a case of more confident financial market participants finding their feet, in our view, but rather a reflection of financial markets unable to see through the smoke and reluctant to pit themselves against their peers going into year-end and/or test monetary authorities’ resolve at time of acute uncertainty. While major currencies (and global equity markets) may well continue to struggle for clear direction in coming days, significant event risk beyond the usual key macro data releases at the very least could result in greater currency volatility in coming weeks, with Sterling a prime candidate.
Brexit & Covid – UK economy and Sterling at a critical juncture
Sterling has been gently buffeted in the past month by a number of inter-related developments. Admittedly one critical concern for the private sector and markets – talk of higher UK taxes to narrow the ballooning UK budget deficit – has seemingly been kicked into touch for now. Chancellor of the Exchequer Rishi Sunak has indicated that he would postpone this autumn’s annual budget to next year, suggesting that the (unavoidable in our view) announcement of higher taxes will also be pushed back to 2021. Moreover, Monetary Policy Council members have on the whole in the past month downplayed the near-term likelihood of the Bank of England cutting its record-low 0.1% policy rate into negative territory.
However, two critical issues cannot be so easily circumvented: i) the odds of the United Kingdom and European Union agreeing to a new trade deal and ii) the impact on already slowing UK economic growth of newly introduced full-blown lockdowns (or “circuit-breakers” as they are being termed) in Wales, Northern Ireland, Scotland, Liverpool and Lancashire. Given the national rise in covid-19 cases in the UK (about 17,000 /day in the past week) and hospitalisation admissions (back to March pre-lockdown levels), it is conceivable that circuit-breakers could be extended to the rest of England, including London, which at present is only subject to stricter social distancing measures.
UK-EU negotiations over new trade deal likely to go to the wire
The UK and EU concluded on 2nd October their ninth and final round of formal negotiations over a new trade deal and a number of stumbling blocks – including UK state subsidies and fishing rights – remain. Both sides have since blown hot and cold, threatening to walk away from talks and prepare for a “no-deal” Brexit only to then make (conditional) promises to resume and intensify (informal) negotiations before once again talking down the odds of a deal being reached. From markets’ perspective it has been a case of “good” and “bad” news equating to “no news” which has in turn merged into “noise”.
But the clock is ticking and time is running out. While the British government’s self-imposed deadline of 15th October for both sides to agree on the broad terms of a deal, coinciding with the start of the European Council’s two-day meeting (see Figure 3), has come and gone – as largely expected – there are hard deadlines ahead. The lead EU negotiator Michel Barnier is willing to negotiate with his British counterpart, David Frost, until early November. However, the past four years suggest that negotiations to nail down the details of such an agreement could continue till the very last minute – which the EU has suggested is mid-November. This would allow sufficient time for national and European parliaments and the European Council to ratify the new trade deal before the UK’s transition agreement, whereby the UK remains in the EU customs union and single market, ends on 31st December.
Assuming that British Prime Minister Johnson is true to his word that he will under no circumstance seek a time extension to the transition agreement, we see three possible broad outcomes with very different implications for Sterling, UK financial markets and the domestic economy in the short and long-term.
Figure 4: Modest net-long Sterling speculative positions have been unwound in recent weeks
Source: 4X Global Research, Bank of England, Commodity Futures Trading Commission, investing.com
Note: * Long positions minus short positions; **NEER is Nominal Effective Exchange Rate
Scenario 1: EU and UK reach agreement on a comprehensive “Canada-style” free-trade agreement
- We would expect Sterling to appreciate materially in the remainder of the year, particularly as the market is currently slightly short Sterling based on net speculative positions data (see Figure 4). However, the likelihood of UK corporates still facing higher import/exports tariffs, the end of frictionless trade with the EU and significant administrative costs could still weigh on the UK economy and Sterling in early 2021.
The decision to leave the customs union and single market will reportedly generate an estimated 215 million customs declarations annually, costing business £7bn, and Cabinet member Michael Gove has not contested industry estimates that 50,000 private sector customs agents will have to be hired to deal with the red tape. The majority of businesses, which are already facing record shop closures and mass redundancies, have acknowledged that they are not ready for trading arrangements which would come into force on 1st January 2021.
Scenario 2: EU and UK reach agreement on a “narrower” trade deal
- In this scenario the EU and UK would reach partial or sectoral free trade agreements, with some transitional arrangements remaining in place for the foreseeable future. We would expect Sterling to appreciate in the short-run but to eventually lose steam and potentially weaken into year-end, particularly if the UK private sector is having to deal with both less advantageous EU trading terms and conditions and the economic strictures associated with a national lockdown, with the crucial service sector already under immense pressure.
Scenario 3: EU and UK fail to reach an agreement on a new trade deal.
- In this scenario the UK would revert to World Trading Organisation (WTO) rules (“hard Brexit”), which would result in the UK facing materially higher trade tariffs and quotas with the EU, likely delays (even if temporary) to UK imports/exports at its “borders” with the EU and the government facing possible EU legal action over its Internal Markets bill. We would expect a non-negligible hit to the open UK economy and for Sterling to come under significant pressure in such a scenario.
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