Bibby FX Brexit Election Update

With just 2 days to go until the General Election, the pound is at multi-month highs against the USD, and over 2 year highs against the EUR, buoyed by the polls that are showing a Conservative majority. Though the markets main fear has been that we get another hung Parliament, the fact that the Tories, perceived as more ‘market friendly’ than Labour, are the front runners has also helped boost sterling over the last couple of weeks. After the election was announced in mid-October, the pound held steady in a USD 1.28-1.30 range for around 6 weeks, until finally breaking through the topside at the start of last week, and the steady unwinding of short positions since has also underpinned sterling. Data from August showed hedge funds and other market speculators had bet record sums against the pound, with over USD 8 billion of short positions in place, but this figure has since reduced to somewhere nearer to USD 2 billion, and though the FX market is the biggest and most liquid market out there, this sort of flow (which will be mirrored in other, unreported segments of the market) still has a significant impact.

This pound rally has come despite UK economic data showing the impact of the Brexit uncertainty, with a marked slowdown in activity and even the previously firm employment situation showing signs of turning recently, prompting two Monetary Policy Committee members to unexpectedly vote for an interest rate cut at the Banks November rate setting meeting. That the pound could rally so strongly against this backdrop shows just how much of a drag Brexit, and the ensuing political stalemate in Parliament has been for sterling, but with a Conservative majority now at least to some extent written into the price, the greater risk now is that the polls have it wrong (not a great stretch given the recent track record), and the election doesn’t bring about the much hoped for clarity.

If we get a working majority for the Conservatives, we could expect a further pound relief rally, though the extent of this may be lessened as it is widely expected, but we may see as high as 1.35 to the dollar, and 1.22 against the EUR in a knee jerk reaction to the result, though from there economic factors should re-emerge as the main market mover and we should see some tempering of those gains. The main risk for the pound is that the polls have been misleading us - and the pollsters themselves say that the numbers of undecided is unprecedented - and we get another hung Parliament. If this occurs, we would expect to see a sharp drop in the pound back to the low 1.20s against the USD, and perhaps the sub EUR 1.10 levels we saw during the summer.

Outside of the UK, the manufacturing slowdown in Germany has become ever more pronounced, hit by both Brexit and global trade fears brought about by the US-SINO trade dispute, and this prompted the then ECB Chief (Super) Mario Draghi to resume the Banks Quantitative Easing programme and reduce bank deposit rates even further at his penultimate rate setting meeting in October. This undermined the EUR, and it has now also become the funding currency of choice for many hedge funds and investors who borrow Euros at virtually no cost, sell them on the FX market and invest in higher yielding currencies and financial instruments. This is known as the ‘carry trade’ and can have a significant negative long term impact on a currency as the figures involved can be huge. The prime example was the hedge fund Long Term Capital Management, who borrowed huge amounts of Japanese Yen in the 1990’s to fund their highly leveraged trading strategies. One of their investments was to buy Russian government debt, and when Russia defaulted in August 1998, the banks who had lent to the hedge fund eventually had to bail the company out, but had to buy back the vast sums of JPY that LTCM had borrowed over almost 4 years to cover the books. The amounts involved were so big that the Yen, one of the most widely traded and liquid currencies in the FX market, appreciated by nearly 20% in 2 days. To put that into context, the pound fell around 10% from its opening level on the day of the EU referendum to its close the day after.

On Thursday, the new ECB Chief, Christine Lagarde, chairs her first rate setting meeting of the ECB Governing Council, and many at that meeting have expressed reservations with Draghi’s QE resumption, and the impact of negative rates in general, so this could be a critical day for the EUR as well the pound. In all likelihood however, Lagarde will probably refrain from reversing her predecessors actions and instead call on EU governments to loosen their fiscal purse strings to help boost the Eurozone’s flagging economies.

So the EUR has its own headwinds, not the least of which is Brexit, and the single currency looks likely to find any gains very hard to find in the coming months..

In the US, the ongoing trade dispute often leads to short term USD safe-haven buying, but the longer term implications are less clear. It could lead to lower consumption in the US, or possibly higher inflation depending on the eventual outcome and timing, but politics are also at play with President Trump facing possible impeachment, and if he survives that his constant FED bashing – calling for the FED to slash US interest rates to weaken the dollar and make US manufacturers more competitive – could also anchor any USD strength. The FED actually meet tomorrow to decide US interest rates, but markets have priced in a 100% certainty that they will not cut again this year after last week’s stellar US Employment report for November, despite the pressure from the Whitehouse…

All in all, there is plenty of scope for further volatility in the days and weeks ahead so please don’t hesitate to get in touch to discuss the FX market in general or your personal currency requirements.