Sterling Lower as Market Waits

Sterling lower as traders look forward to inflation data

The pound, which has been buoyed for the past month by optimism that the UK will be able to negotiate a favourable trade deal following its departure from the EU, fell to the bottom of its recent ranges yesterday. Traders are beginning to focus on next week’s inflation data and employment report. Inflation has become the single most important macroeconomic driver for the currency as it is the focus of the Bank of England and therefore monetary policy.

When it raised rates in early November, the MPC commented that while it expected inflation to fall, it doubted it would to do so without a tightening of monetary policy. Traders are now waiting to see if inflation, which remained unchanged at 3.1% in November, fell in December. The pound made a low of 1.3481 yesterday versus a dollar which was also on the back foot. Versus the Euro, it fell to a low of 1.1271 before recovering but the fall has resumed overnight in Asian trade.

The path for the pound in the short term is difficult to project given that were inflation to fall it would drive an expectation that the rate hike had had the desired effect and no further rise was likely until Q4 at the earliest. However, were the December rate of inflation to rise, it could mean higher rates sooner but would, dependent upon the employment report, mean a widening of the gap between wages and prices.

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China flexes its financial muscles

While the U.S. is the world’s largest consumer, China is the world’s largest manufacturer. This is illustrated by the consistently wide trade gap the U.S. reports every month. The flow of goods from China to the U.S. is matched by the flow of capital in the opposite direction. But, since U.S. market is, currently, not only the only one large enough to accommodate the size of investment China makes but it is, for now, the most secure. Even President Trump understand the role China plays in the U.S. economy which is why he tends to “play nice” with Chinese Premier Xi Jinping.

The merest hint of a shift in Chinese purchases of U.S. Treasuries can have a major effect of sentiment for both the bond market and the dollar. Such a scenario was played out yesterday as China signalled that it may be ready to slow down or halt its purchases of U.S. securities. China holds all the cards in this situation, with the Euro starting to exhibit the necessary stability to become a serious competitor to the dollar as a reserve currency even a minor shift in Chinese investment plans could see major rise in the value of the single currency. Yesterday, the dollar index dipped below the 92.00 level before recovering as the euro briefly traded above 1.2000. It closed at 1.1955, a twenty-point rise on the day.

Market awaits new factors

Investors have reached a difficult period as they await the results of their portfolio decisions for 2018. They have studied the likely drivers for currencies and other assets but now await the emergence of the anticipated drivers to prove their decisions. In the case of the pound, Brexit talks which don’t resume until March will be the single significant factor.

There has been an air of expectation surrounding the pound as the optimism engendered by the agreement reached in December over the move to stage two of talks has fuelled hopes of a smooth transition. It is hard to make such a case in my opinion since the EU demonstrated that it wasn’t prepared to provide any concessions in the first round and by “digging in its heels” managed to drive a capitulation by the UK. The only good news as far as Brexit is concerned is that the threat of a “Hard Brexit” has virtually disappeared which should be positive for the currency if not the Brexit hawks.

In the Eurozone, speculation surrounds the timing of the withdrawal of additional stimulus in the shape of the Asset Purchase Scheme. While the withdrawal will be positive for the currency, there are concerns about the losses the ECB may incur following the fall in value of the bonds they have purchased.