Can Theresa May save the pound?
All eyes will be on British PM Theresa May as she makes her way to Salzburg today to address EU leaders over dinner this evening. This informal summit is considered a turning point for Brexit: will the UK be able to pull the ultimate deal (single market access and frictionless trade, minus free movement of people) from the grip of an EU intent on denying her a cherry-picked deal?
Analysis: growing optimism boosts GBP
While it is still deeply unlikely that the UK will get exactly what Theresa May wants from Brexit, the news flow and the pound are starting to warm up to the idea that Brexit may not be that bad. Some interesting analysis: the number of stories featuring the term “no deal Brexit” has dropped sharply since mid-August (according to Bloomberg), which has coincided with a pick up in the pound. In contrast, between June and mid-August there was a glut of “no deal Brexit” stories, which coincided with the pound falling more than 5% vs. the USD over the same time period. This tells us a few things: 1, FX traders read the news, so news flow is integral for the pound right now, and 2, if sentiment sours between the UK and EU at this summit, making a “no deal” scenario more likely, then we could see the pound tumble.
So, although this Salzburg summit is informal and no concrete action is likely to come out of it, sentiment from the summit is mightily important for the direction of the pound right now.
Beware being too positive on Salzburg
Momentum is on the pound’s side as we lead up to the summit, it has rallied some 1.3% this week, however, when a currency is driven by news flow it becomes vulnerable to whipsaw price action. The FX market is positively buoyant leading into this summit, which means that it is especially vulnerable to any negative fall out from the meetings, that take place.
Why China tariffs don’t matter for US stocks
Elsewhere, US stocks are mostly brushing off the threat of more US/ China trade tariffs. There are two reasons for this in our view. Firstly, the tariffs were not as bad as some expected (10% on $200bn of Chinese imports). Secondly, trade war concerns are already “priced in” by the stock market, so trade wars, even if they escalate further, may not be enough to tip the US markets over the edge. The reason why markets seem insulated from trade war rhetoric is that ultimately the US does import significantly more from China than China does from the US, so retaliatory moves from China is unlikely to have a negative impact on the US economy.
Why the USD hasn’t followed Treasury yields higher
A potentially more worrying trend is the sharp rise in US Treasury yields, with the 10-year yield jumping above 10% to a 4-month high. Interestingly, the dollar has developed an inverse correlation to Treasury yields, and rather than rise on the back of a higher yield it has fallen some 2.75% in the last month. This could be a sign that the FX market is pricing in a slower rate of growth for the US, as higher interest rates start to bite. A weaker dollar could take some of the strain off of emerging markets from rising Treasury yields, and so far emerging market equity indices have held up well in the face of higher US borrowing costs. However, they continue to remain vulnerable to a higher dollar.
Why CPI is unlikely to break the pound’s recent run
Elsewhere, the market will also focus on the outcome of the BOJ meeting and UK CPI, which is expected to fall further and could boost real wages even more. If the CPI numbers are in line with expectations then even though weaker inflation could marginally reduce the chance of a February rate hike from the BOE, the fact that it could boost consumer spending should not disrupt the pound’s decent run and 1.3200 ahead of 1.3250 could be in sight.
Why the lira could come under attack once more
In the FX space, commodity currencies are benefitting from the jump in the oil price on Tuesday. In the EM FX space, the lira is once again bottom of the pack and fell more than 1% vs. the USD on Tuesday. This came on the back of a jump to above 10% in the unemployment rate for June, and a much weaker budget balance of -$5.8bn for August, after a +£1.1bn reading in July. Both figures are expected to get worse over the coming months. The market is still testing the CBRT to do more to support the currency, after the central bank hiked rates sharply last week; however, if we continue to see a sharp weakening of the economic data, the lira may be beyond saving.