Brexit – What next?

The drubbing that the main UK political parties (Conservatives and Labour) received in the European elections highlights the increasing polarisation of UK politics.  Both took a fudged view on how to go about Brexit while the remainers including the Lib Dems and the hard brexiters led by the newly formed Brexit Part, garnered most votes.  The outcome sends a clear signal of public frustration and impatience at the lack of progress in leaving the EU three years after the Brexit referendum.

A new leader of the Conservative party will likely steer towards a harder Brexit, but this may not resolve the impasse, something that has already brought down Prime Minister Theresa May.  In any case it is unlikely that the EU will want to renegotiate the terms of the Brexit deal agreed with May just because there is a new leader.  Divisions within the Conservative party itself continue to remain stark.  In the meantime Labour leader Corbyn is under pressure to make a clearer shift towards remaining in the EU.

Parliament meanwhile, has already voted against allowing a hard Brexit, suggesting that it is going to be extremely difficult to deliver a no deal or hard Brexit without fresh general elections.  However, as the European elections have shown, fresh UK general elections would spell doom for both the Conservatives and Labour unless they moved to harder stances on either side of the spectrum.  The Conservatives may not risk such an outcome.

This leaves a second referendum as an increasingly viable option, one which would put the question of remaining or a hard Brexit back to the public and out of the hands of parliament.  Indeed given the lack of alternatives and inability of parliament to move forward on Brexit, this may turn out to be the most prescient option although this runs risks of its own including fuelling demands for a fresh Scottish referendum.

GBP has continued to slide amid a clear lack of progress among politicians to arrive at a viable Brexit strategy and increasing risks of a hard Brexit.  However, if markets see a growing chance of a fresh referendum, GBPUSD could reverse some of its recent losses as remain hopes are rekindled, possibly breaking back above 1.30 at the least.   It is not by any means clear that remainers would win such a referendum, but at least they would have a chance that did not exist previously and that could be sufficient to give GBP a bounce.

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All Eyes On Europe

EUR looks range bound ahead of key events including the European Central Bank (ECB) meeting, European Union Summit and release of bank stress test results. A senior German official poured cold water over expectations of a concrete outcome from the EU Summit, dampening EUR sentiment as a result.

There will be plenty of attention on the ECB to determine whether they will give a little more ground and provide further assistance to the Eurozone periphery. While a refi policy rate cut is highly likely as well as additional liquidity measures I do not expect any move in the direction of more aggressive action to support peripheral bonds in terms of becoming “lender of the last resort’.

If however, the ECB hints at intensifying its securities market purchases of Eurozone bonds this will likely bode well for the EUR. Indeed, reports overnight suggest that the ECB will announce a set of measures to stimulate bank lending including easing collateral requirements for banks.

More weak UK data in the form a bigger than consensus drop in manufacturing and industrial production in October add to the soft BRC retail sales and house price data, in putting pressure on the Bank of England (BoE) to increase its quantitative easing at today’s policy meeting. While the BoE is set to keep policy unchanged it is only a matter of time before additional asset purchases are announced.

Despite the weaker IP data GBP has held up relatively well against the USD although downside risks appear to be intensifying. If I am correct in the view of no change by the BoE today we expect little change in GBP although there could be a risk of a push higher in EUR/GBP if the ECB delivers some positive news, with resistance seen around 0.8665.

The RBNZ unsurprisingly left policy rates unchanged at 2.5%, sounded less hawkish than the previous meeting and also lowered growth forecasts. The NZD was left unmoved by the rate decision and looks well supported at current levels perhaps due to relief that the statement was not more dovish. The kiwi has been an underperformer over the year but unlike the AUD it has not been particularly influenced by gyrations in risk aversion.

Interest rate futures differentials have seen a renewed widening versus the US over recent weeks. This is significant given that the NZ-US interest rate differentials have a very strong correlation with the performance of NZD/USD. If this widening is sustained it will point to upside potential for the Kiwi.

Greece throws a spanner in the works

Having already retraced around 50% of its losses from its high around 4 April to its low on 27 October the USD index is on a firm footing and looks set to extend gains. The USD is benefitting both from the EUR’s woes and receding expectations of more US quantitative easing in the wake of less negative US data releases.

Whether the USD is able to build on its gains will depend on the outcome of the Fed FOMC meeting, accompanying statement and press conference today. While there have been some noises from Fed officials about the prospects of more QE, the Fed is likely to keep policy settings unchanged, leaving the USD on the front foot.

Greece has thrown a spanner in the works by calling a national referendum on the European deal. The fact that this referendum may not take place until January will bring about a prolonged period of uncertainty and further downside risks for the EUR against the USD and on the crosses. As a result of the increased uncertainty from the referendum, growing doubts about various aspects of last week’s agreement as well as hesitation from emerging market investors to buy into any European investment vehicle, peripheral bond spreads blew out further, and the EUR dropped.

The immediate focus will be on emergency talks today between European leaders in Cannes where Greek Prime Minister Papandreou has been summoned at a time when his grip on power appears to be slipping ahead of a government confidence vote on Friday. EUR/USD looks set to slip to support around 1.3525.

The Swiss National Bank’s floor under EUR/CHF has held up well since it was implemented in early September. How well it can be sustained going forward is questionable especially given that risk aversion is intensifying once again. A weaker than forecast reading for the Swiss October manufacturing PMI yesterday falling further below the 50 boom / bust reading to 46.9 highlights the growing economic risks and consequent pressure to prevent the CHF from strengthening further. However, now that Japan has shown its teeth in the form of FX intervention the CHF may find itself once again as the target of safe haven flows.

Technical indicators revealed that GBP was overbought and its correction lower was well overdue. However, GBP looks in better shape than the EUR even in the wake of some mixed UK data yesterday. On a positive note, UK Q3 GDP surprised on the upside in line with our expectations coming in at 0.5% QoQ. However, the forward looking PMI manufacturing index dropped more than expected in October, down to 47.4 suggesting that UK economic momentum is waning quickly.

EUR/GBP looks set to test its 12 September low around 0.8259 but GBP/USD remains vulnerable to a further pull back against a resurgent USD. Overall, GBP’s resilience despite the implementation of more quantitative easing by the Bank of England has been impressive and I expect it to continue to benefit from its semi safe haven status

Payrolls sour mood, Eurozone concerns intensify

The market mood has soured further and risk aversion has increased following disappointing August US jobs report in which the change in payrolls was zero and downward revisions to previous months has reinforced the negative mood on the US and global economy while raising expectations of more Federal Reserve action. Moreover, the report has put additional pressure on US President Obama to deliver fresh jobs measures in his speech on Thursday though Republican opposition may leave Obama with little actual leeway for further stimulus.

There is plenty of event risk over coming days, with a heavy slate central bank meetings including in Europe, UK, Japan, Australia, Canada and Sweden. The European Central Bank will offer no support to a EUR that is coming under growing pressure, with the Bank set to take a more neutral tone to policy compared its previously hawkish stance. In the UK, GBP could also trade cautiously given recent comments by Bank of England Monetary Policy Committee members about potential for more UK quantitative easing.

The EUR has been unable to capitalise on the bad economic news in the US as news there has been even worse. The negative news includes the weekend defeat of German Chancellor Merkel’s centre-right bloc in regional elections, which comes ahead of a vote in Germany’s constitutional court on changes to the EFSF bailout fund.

The withdrawal of the Troika (ECB, IMF and EU) from Greece has also put renewed emphasis on the country at a time when protests are escalating. If all of this is not enough there is growing concern about Italy’s apparent backtracking on austerity measures, with the Italian parliament set to discuss measures this week. Separately Germany, Holland and Finland will hold a meeting tomorrow on the Greek collateral issue. On top of all of this is the growing evidence of deteriorating growth in the euro area.

Data releases are unlikely to garner a great deal of attention amidst the events noted above, with mainly service sector purchasing managers indices on tap and at least threw will look somewhat better than their manufacturing counterparts. In the US the Beige Book and trade data will be in focus but all eyes will be on Obama’s speech later in the week. The USD has maintained a firm tone despite the jobs report but its resilience may be better explained by eurozone negativity rather than US positivity. Even so, the USD is looking less uglier than the EUR in the current environment.

Awaiting US jobs data

The USD continues to languish as market hopes/expectations of further US Federal Reserve stimulus including possibly more quantitative easing or QE3 weigh on the currency. There may also be some hesitation to buy USDs ahead of tomorrow’s August jobs report. The omens from the US ADP jobs data yesterday were not particularly positive, with a below consensus 91k private jobs reported.

As the Fed FOMC minutes earlier this week highlighted there are a few in the FOMC who are prepared to take more aggressive action which would equate to an even weaker USD. Ahead of the jobs data today’s August ISM manufacturing survey will offer some direction for markets but if our forecast of a sub 50 outcome proves correct it will only play into expectations of more Fed stimulus leaving the USD on the back foot.

EUR/USD struggled to sustain any move above 1.45 this week but has continued to withstand various peripheral bond concerns without too much difficulty, an ability it has managed to maintain for the past several months. Although it has pulled back EUR/USD may struggle to sustain a drop below its 100-day moving average at 1.4362.

Although there have been various fresh worries over recent days such as the collateral issues between Greece and Finland as well as well as questions about German demands for Greece’s bailout, the EUR is likely to remain unperturbed. Whether the EUR will be able to withstand growing evidence of slowing growth in the eurozone is another question altogether, especially as it is leading to a reassessment of European Central Bank (ECB) policy expectations, something that will likely be confirmed at next week’s ECB meeting.

GBP has had problems of its own to deal with and has failed to capitalise on any USD tone while losing ground against the EUR. Data yesterday did not help, with consumer sentiment falling for a third straight month according to the GfK confidence index. It appears that speculation of further Fed monetary stimulus may also be rubbing off on GBP, with potential for more UK QE likely to act as a weight on the currency.

Bank of England MPC member Posen added fuel to the fire in comments that he made supporting the need for central banks to undertake more QE. GBP looks destined for more weakness in the short term, with support around GBP/USD likely 1.6111 likely to be tested. A below 50 reading for the August manufacturing PMI today, will only add to downside pressure.

Euro Resilience To Fade

There will at least be a little more liquidity in FX markets today following yesterday’s public holidays in the US and UK. Whether this means that there will be a break out of recent ranges is another matter. Clearly global growth worries as well as eurozone peripheral debt concerns are having an important impact on market dynamics but are also providing conflicting signals.

On the one hand the USD ought to garner support from Europe’s problems but on the other, safe haven demand and growth concerns is bolstering demand for US Treasuries keeping US bond yields at very low levels despite the lack of progress on increasing the US debt ceiling and agreeing on medium to long term deficit reduction.

In the wake of a run of US data disappointments including April durable goods orders, Q1 GDP and weekly jobless claims last week, fears of a loss of momentum in the US economy have intensified. Manufacturing and consumer confidence surveys in the form of the May Chicago PMI and Conference Board consumer confidence survey today will be closely scrutinised to determine whether the ‘soft patch’ in the US economy will persist.

This will have important implications for the USD as worries about growth may feed into expectations that the Fed’s ultra loose monetary policy will be sustained for longer. As it is US 2-year bond yields have dropped to their lowest level this year.

Fortunately for the USD only USD/JPY and USD/CHF have maintained a statistically strong correlation with bond yield differentials although we expect the break in relationship for other currencies to prove temporary. In the case of USD/JPY, yield differentials have narrowed between the US and Japan, a factor playing for JPY appreciation.

Perhaps the fact that unlike the US Japanese data has on balance been beating expectations notwithstanding disappointing April household spending and industrial output data has helped to narrow the yield gap with the US. One explanation is that that worst fears of post earthquake weakness have not been borne out, suggesting that economic expectations have been overly pessimistic. In any case, USD/JPY 80 is still a major line in the sand for the currency pair.

The EUR continues to show impressive resistance, with EUR/USD breaking technical resistance around 1.4345, which opens up a test of 1.4423. Reports that Greece had failed to meet any of its fiscal targets and of harsh conditions set by European officials for further aid have failed to dent the EUR. Whether the market is simply becoming fatigued or complacent will be important to determine if the EUR can gain further.

A report in the WSJ that Germany is considering dropping its push for early rescheduling of Greek debt has given some support to the EUR too. Ongoing discussions this week are unlikely to prove conclusive however, with attention turning to meetings of European officials on 20th and 24th June. I still believe EUR gains will limited, with the break above 1.4345 likely to prove shortlived.

Greece’s trials and tribulations

Two main influences on markets continue to weigh on sentiment. Firstly the trials and tribulations of the eurozone periphery remain centre of attention. The failure of Greek Prime Minister Papandreou to win cross party support for austerity measures at the end of last week highlights the problems Greece is facing both domestically and externally.

Reports that European officials are negotiating tough bailout conditions including major external intervention in terms of tax collection and privatisation suggest that gaining further aid will not be easy. The second weight on market sentiment is global growth concerns, with a string of disappointing data releases over recent weeks leading to an intensification of concerns about the pace of recovery.

Markets will likely remain nervous in this environment and it is difficult to see risk appetite improving to any major degree. This has proven bullish for bond markets, with the tone set to continue this week. Currencies remain in ranges and holidays today in the US and UK will likely result in thin trading. The resilience of the EUR to peripheral concerns has been impressive but at the same time Greek concerns will limit any gains. Meanwhile, gold and precious metals look to remain well supported, with gold’s safe haven bid remaining solid.

USD sentiment has improved sharply according to the latest CFTC IMM report which reveals that net USD short positions have been cut in half over the last two weeks with positioning well above the 3-month average. Conversely net EUR longs continue to shrink as speculative investors off load the currency. The fact that the EUR is not weaker than it is points to the influence of official demand for the currency, especially from Asia.

This week will likely be dominated by ongoing discussions about Greece and given the opposition to austerity measures and potentially strict bailout terms, forging an agreement will not be easy. Reports suggest that around half of Greece’s financing needs until the end of 2013 could be accounted for without new loans via privatisation and changes in terms for private bondholders, with Europe and the IMF needed to lend an additional EUR 30-35 billion on top of the EUR 110 already slated.

Data releases are likely to take a back seat but there will still be plenty of attention on the key release of the week, namely the May US jobs report. The market looks for a 185k increase in payrolls, with the unemployment rate edging lower to 8.9%. This would mark the lowest payrolls reading in 4 months. Clues to the jobs data will be garnered from the May ADP jobs report, ISM manufacturing survey and consumer confidence data earlier in the week.

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