Dead cats bounce much higher when they’re dropped from great heights. The pound sterling is sitting on its biggest weekly gain in more than a decade, with improving political conditions and yesterday’s surprisingly measured response from the Bank of England helping to lift it by more than 3.5% over the last five days.
A surprisingly swift conclusion to the Machiavellian Conservative Party leadership race has had a profound effect on market expectations, convincing many observers that the United Kingdom will manage to extricate itself from the European Union with a minimum of fuss. Although incoming Prime Minister Theresa May has emphasized her belief that “Brexit means Brexit”, she also pledged to make a success of the situation in several speeches over the past few days. In doing so, she has acted to assuage fears among those who campaigned on the Leave side of the referendum of a paradoxical or meaningless reaction to the vote – while assuring Remainers that her government will negotiate a reasonably beneficial and sustainable deal with lawmakers on the Continent.
Building on this sense of relief, Mark Carney did what he does best yesterday, calming markets and averting some of the economic despair that has become so prevalent over the past few weeks. In deciding to wait until August before unleashing a series of stimulus measures, the Bank of England negotiated an extraordinarily difficult balancing act with aplomb – convincing participants that the situation isn’t catastrophic, while assuring them that help is on its way.
In comments after the meeting, Chief Economist Andy Haldane said, “Given the scale of insurance required, a package of mutually-complementary monetary policy easing measures is likely to be necessary. This monetary response, if it is to buttress expectations and confidence, needs I think, to be delivered promptly as well as muscularly. By promptly I mean next month, when the precise size and extent of the necessary stimulatory measures can be determined as part of the August Inflation Report round.”
Currency markets now expect the Bank to deliver a 25 basis point cut in benchmark lending rates by the end of August, accompanied by some combination of asset purchases. This is less dramatic than was expected only a week ago, when rates were forecast to drop to zero, falling by 50 points before September – but could still act to stall a nascent relief rally in its tracks. For corporates selling sterling, we would strongly consider fading some of these gains before the next meeting.
As fear ebbs globally, the perceived need for safe havens is rapidly evaporating, and risk-sensitive assets are seeing solid gains. With investors increasingly expecting another round of monetary and fiscal stimulus from the Abe government, the Japanese yen has lost more than 5% of its value in a week – effectively outpacing the pound in the opposite direction.
Many emerging market currencies are up sharply, rebounding in response to a relatively robust raft of economic data out of China last night. According to official numbers, output grew 1.8% in the second quarter, putting the country on track for a 6.7% expansion on a year-over-year basis. Fixed investment fell from 9.6% to 9.0%, but a massive increase in government spending helped to offset this in stabilizing growth.
For those China pandas out there, it wasn’t all carrots and green shoots unfortunately. Total social financing jumped to 1.63 trillion renminbi, from 660 billion in May, suggesting that the country’s rebalancing efforts continue to meet serious opposition. As external receipts lose momentum, policymakers are increasingly relying on debt issuance to prop up failing companies and real estate markets. It’s still possible for this to end well, with other areas of the economy gradually coming into their own – but the longer that this pattern continues, the more likely it is that China will suffer a major correction.
Here in the land led by a Clairol model, the loonie is heading into the weekend on a remarkably firm footing. To our surprise, the week’s plunge in front-month crude prices has done little to ruffle the loonie’s feathers, with currency traders ignoring a rapidly deteriorating oil demand and supply balance, instead focusing on overall risk sentiment in setting the exchange rate. As discussed in recent missives, we expect to see this pattern continue until the Canadian housing market turns, or until activity falls in the autumn months.
Finally, to round out our coverage of the majors, the American dollar is exhibiting an interesting trading pattern, rising into the weekend as cautiously optimistic traders begin to raise the odds of a Federal Reserve rate hike landing before year end. Several Bank presidents have now said that they don’t expect Brexit to upset the US economy’s trajectory, with the influential Atlanta Fed chief Dennis Lockhart saying yesterday that he sees a “negligible near-term effect, a risk factor over the medium term, higher uncertainty that could amount to a persistent economic headwind” while Patrick Harker at the Philly Fed said “Brexit is low on my list of risks, and I do not anticipate more than a transitory couple of tenths of a percentage point slowdown in growth”.
In combination with our view that the US economy remains the rock in a sea of troubles with enough momentum behind it to unhook itself from global uncertainties, we believe that the odds of at least one hike before January are better than fifty-fifty. In the event that the market comes around to this perspective in the coming months, we could see yields steepen, supporting another bout of dollar strength – with implications for a number of other asset classes.
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