22 October 2020

Dollar, Euro & Sterling’s Tug of War

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Financial markets have shined a spotlight on Dollar, Euro and Sterling

Financial markets in recent months have arguably focussed on the US Dollar, Euro and Sterling and not just because they are major reserve currencies and EUR/USD and GBP/USD are amongst the most actively traded crosses in the world. Forthcoming US presidential elections, 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, 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 are among the critical issues which have shined the spotlight on these three currencies.

And yet the EUR/USD cross and even the more risk-sensitive GBP/USD cross are currently unchanged from a month ago, having traded in narrow ranges of just 2-2.5% (see Figure 1). Only the Canadian Dollar, safe-haven Swiss Franc and heavily-managed Asian currencies have traded in comparable or narrower ranges.

Figure 1: Euro and Sterling have traded in narrow ranges and shown little directionality versus US Dollar
Source: 4X Global Research, Federal Reserve, investing.com
Note: * US Dollar Nominal Effective Exchange Rate (Federal Reserve trade weights)

Moreover, daily realized volatility in these crosses has been subdued (see Figure 2). Our measure of volatility – the 10-day standard deviation in the daily percentage change in US Dollar pairs (using spot closing prices) – has fallen sharply in the past month for GBP/USD and remained modest for EUR/USD (the latter currently stands at around 0.34, below its 10-year average of about 0.5). Put differently daily moves in Sterling and the Euro have on the whole been “orderly”, even if intra-day volatility has spiked on occasion.

Figure 2: Realized volatility in EUR/USD and GBP/USD remains modest in absolute and relative terms
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 Euro and Sterling have thus exhibited negligible directionality, narrow trading ranges and modest volatility. The same could be said of the S&P 500 which has traded in a 10.5%-wide range since late-July. This is not a case of more confident financial market participants finding their feet, but rather a reflexion 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 the Dollar, Euro and Sterling (and global equity markets) may well continue to struggle for clear directionality in coming weeks, significant event risk beyond the usual key macro data releases at the very least could result in greater currency volatility (see Figure 3).

Figure 3: Event risk for Dollar, Sterling and Euro is significant in next four weeks
Source: 4X Global Research, Bank of England, European Council, European Central Bank, Federal Reserve, US Bureau of Economic Analysis, US Bureau of Labour Statistics

Dollar trading like a safe-haven currency but outlook clouded by presidential elections

Dollar market sentiment has arguably been bearish in the past couple of months and yet the Dollar Nominal Effective Exchange Rate (NEER) – a weighted average of the Dollar’s exchange rates against the currencies of the United States’ main trading partners – has oscillated in a narrow range of just 2.7% since late-July (see Figure 4). As noted above the Dollar in the past five weeks has been particularly stable against other major developed currencies, including the Euro, Sterling, Canadian Dollar and safe-haven Swiss Franc and Japanese Yen (see Figure 1).

While the Dollar’s end-September rally and sell-off was likely due in part to end-quarter rebalancing flows and sharp gyrations in the Mexican Peso (which has the third largest weight in the Dollar NEER), the Dollar’s underlying performance is largely a reflection of its “safe-haven” status. Indeed in the past eight months the Dollar has been inversely correlated with the S&P 500, with the exception of brief periods in June and September (grey boxes in Figure 4). Market participants tend to buy/sell Dollars when global risk appetite, as measured by the S&P 500, is weak/strong on the premise that Dollar demand (from non-US central banks and corporates) will be stronger/weaker. Therefore strong US macro data, to the extent that they support US equities, can often result – somewhat counter-intuitively – in a weaker, not stronger Dollar.

Figure 4: The Dollar continues to trade like a safe-haven currency, inversely correlated with S&P 500
Source: 4X Global Research, Federal Reserve, investing.com

A broadly stable Dollar has arguably made it easier, all other things being equal, for Middle East central banks to manage and maintain their currency pegs. Had the Dollar appreciated (as it did in March) this would have made it more costly for them to maintain their Dollar-pegs. Conversely, had the Dollar continued to weaken (as it did in May-July), this would have likely increased the cost of imports, pushed up inflation and weakened domestic consumers’ purchasing power (and been of little benefit to the domestic tourism/travel industry due to international travel restrictions and pandemic-related measures).

This inverse relationship between a weaker Dollar and stronger S&P 500 has broadly held true since US President Trump announced on 2nd October that he had tested positive for covid-19, along with the First Lady and a number of senior US officials. President Trump has since reportedly tested negative for covid-19 and the question is once again how the outcome of the US presidential election on 3rd November will impact financial markets. Our take is that markets remain undecided whether a Trump or Biden victory will be a net positive for the Dollar or US equities, even if the implications for specific industries and stocks may be more obvious. An unequivocal and clear-cut victory for either candidate could therefore buoy global risk appetite and thus weigh on the Dollar. Put differently, if the election result is very close and/or requires material re-counts of county or state votes and is contested by either candidate, a prolonged period of uncertainty could weigh on market sentiment and perversely see the Dollar appreciate.

Brexit, Covid and fiscal policy – UK economy and Sterling at a critical juncture

Sterling has been buffeted in the past month by a number of inter-related issues (see Figure 5). Admittedly one critical concern for the private sector and markets – talk of higher UK taxes to narrow the ballooning 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 three weeks played down the near-term likelihood of the Bank of England cutting its record-low 0.1% policy rate into negative territory.

Figure 5: 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

However, the interplay between old and new fiscal stimulus measures, (slowing) UK economic growth and rising unemployment remains a fundamental challenge. Moreover, two other 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 an already fragile UK economy of newly introduced lockdown and social distancing measures which currently apply to Northern England, Wales and Northern Ireland but could conceivably be extended to the rest of the country, including London.

The UK and EU have concluded their ninth and final round of formal negotiations over a new trade deal and both sides have made positive noises. However, a number of stumbling blocks – including UK state subsidies and fishing rights – remain and the clock is ticking. The British government has self-imposed a 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). At the top of the EU leaders’ agenda will be an evaluation of negotiations so far between the UK and EU. The EU is reportedly willing to negotiate until mid-November to nail down the details of such an agreement. 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 outcomes with very different implications for Sterling, UK financial markets and the domestic economy.

Figure 6: Modest net-long 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 in the next month reach agreement on a “comprehensive” trade deal which comes into force on 1st January 2021.

  • Sterling could 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 6). However, the likelihood of UK corporates still facing higher import/exports tariffs and the end of frictionless trade with the EU could still weigh on the UK economy and Sterling in early 2021.

Scenario 2: EU and UK reach agreement on a “narrower” trade deal which comes into force on 1st January 2021.

  • Sterling could appreciate in the short-run but eventually lose steam, particularly if the private sector is having to deal with less advantageous EU trading terms and the economic strictures associated with a national lockdown. The bulk of the government’s lockdown and social distancing measures currently apply mostly to towns and regions in Northern England, Wales and Northern Ireland. However, given  the rise in covid-19 cases in the UK (14,600/day in the past week) and hospitalisation admissions (back to March pre-lockdown levels), there may be a non-negligible risk of further social distancing restrictions being applied to the rest of the UK. This could have a particularly negative impact on an already under pressure service sector.

 

Scenario 3: EU and UK fail to reach an agreement on a new trade deal and UK reverts to World Trading Organisation (WTO) rules.

  • A “hard Brexit” could result in the UK facing materially higher trade tariffs with the EU (and the government facing possible EU legal action over its Internal Markets bill) and likely (material) delays to its imports/exports at its “borders” with the EU. We could 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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