The British pound, Brexit and Tory politics
The US dollar's bid vanished as the foreign exchange market digested the below consensus rise in consumer price inflation (CPI) on Friday, October 13. Yet I doubt if CPI alone will be enough to change the market's expectations of a rate hike at the December FOMC, let alone change the Federal Reserve's balance sheet shrinkage timetable. In any case, the fall in September new and used car prices accounted for the muted inflation data. So the fall in the ten-year US Treasury note yield to 2.27 per cent is due to Asian central bank reserve accumulation, not a shift in inflation expectations.
After all, the implied yield on the December Fed Funds futures contract was unchanged last week at 1.25 per cent. Sterling's strength above 1.32 is thus untenable, especially give the impasse in Brexit it negotiations over a EU trade deal. Chancellor Hammond's reference to the EU as the "enemy" has also poisoned the atmosphere of the negotiations. His comments underscore the divisions and distrust in the British Cabinet on Brexit.
The rise in the British pound to 1.3650 against the US dollar in mid-September reflected the "soft Brexit" consensus of the foreign exchange market reflected in Prime Minister Theresa May's Florence speech. In addition, the financial markets have assumed that the Bank of England will be the third G-7 central bank, after the Federal Reserve and the Bank of Canada, to raise its policy rate given the rise in petrol/food price inflation triggered by the sheer scale of the post referendum devaluation.
In retrospect, political divisions in the British Cabinet make it clear that the "soft Brexit" consensus is premature, the reason cable peaked at 1.3660 on September 20. UK data were a disappointment and the stronger US dollar bid on blowout manufacturing data also added to the consistent sterling selling momentum in the past two weeks.
The City of London grapevine also alleges that Foreign Secretary Boris Johnson is plotting a "hardline Brexit" revolt in Downing Street, a definite bearish, (if improbable) scenario for sterling on the road to Brexit. Yet the ghosts of Mrs Thatcher, Neville Chamberlin, Sir Anthony Eden and Edward Heath remind me that regicide is a hallmark of Tory politics and cannot really be discounted in the age of "blond ambition"!
The sterling rally that began in late August at 1.28 and ended on September 20 at 1.3660 has now done a 4 big figure trend reversal. The 61.8 per cent Fibonacci retracement target suggests sterling will trade down to 1.31 against the US dollar. Trend following, momentum and stochastic indicators are now all against sterling. We could be near the point of maximum bearishness where it would make strategic sense for a long sterling trade near 1.31 for a corrective move to 1.34.
I believe a turnaround in sterling needs two catalysts. One, Mrs May should demonstrate to the world that her vision of a "soft Brexit" is the consensus (if not unanimous) view of the British Cabinet. If Mrs May decides to sack Foreign Secretary Boris Johnson, the currency markets will scramble to buy sterling. Two, the Bank of England should make hawkish statements on inflation. The problem is that while the post referendum UK economy has slowed down, the pass-through inflation caused by sterling's decline has not really peaked. For now, sterling was far more sensitive to the fall in construction and manufacturing PMI's as well as the money market's interest rate expectations.
Last year, it was rational for Mark Carney and the MPC cut the policy rate and resumed their gilt purchase program as insurance against a post Brexit High Street recession that never happened. However, monetary policy accommodation is no longer an imperative, though I concede that the momentum of the UK economy will decelerate this autumn (heresy of heresies, even London home prices have fallen) and the UK consumer has obviously taken a purchasing power hit from sterling's draconian post Brexit decline. The politics of Brexit, in Westminster as well as in Brussels, will dominate monetary policy debates on Threadneedle Street. For instance, despite Mrs May's conciliatory speech, the European Parliament voted 557-92 against starting a new phase of Brexit negotiations. The Jamaica coalition in Berlin is another political wild card, as are events in Catalonia and Madrid.
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