Political Risk Tops Rate hopes

The long road lower

Having rallied substantially recently on the back of a weaker dollar, then driven by the more hawkish than expected Bank of England comments last week, Sterling is facing up to the economic and political reality of Brexit.

The pound fell against the single currency yesterday reaching a low of 1.1246. It has now lost more than 1.6% since the high seen last Thursday following the Monetary Policy Committee meeting.

The comments from EU Chief Negotiator Michel Barnier about a transition period not being a “given” continue to resonate with traders who are weighing up the economic reality of the UK not being a member of the EU single market and customs union against the prospect of higher global growth.

It is hard to see how the UK will benefit from higher global growth going forward as it negotiates its departure from the EU. The pound, which has rallied recently, driven primarily by a weakening dollar has started to reverse those gains and is set to test long term support at 1.3720.

If no transition period can be agreed and it appears M. Barnier is doubtful that the UK will accept EU terms and conditions, the UK faces the prospect of leaving the EU in March next year, ill-prepared for the turmoil that could bring.

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Inflation data to drive short term direction.

Today sees the release of inflation data in the UK for January. It is becoming difficult to predict the direction of inflation as the pound moves away from its recent highs, yet the full effect of last November’s rate hike has not been fully realized.

Analysts predict a fall in the headline number to 2.9% which will alleviate part of the reason for a further rate hike in the short term and this would contradict to a certain extent the more hawkish nature of the Bank of England’s recent Quarterly Inflation Report.

The formerly most dovish member of the MPC, Gertjan Vlieghe spoke yesterday of his belief that the UK economy can withstand a hike in rates as tight labour markets are finally feeding through into wage inflation. He also commented that “the willingness of households to increase their level of debt demonstrates that the economy is “ready” for higher rates”.

That willingness to borrow could also be interpreted as their need to bridge the gap between wages and prices but as Vlieghe said yesterday, “it depends on how the economy develops over the next twelve months”. The increase in hourly earnings released next week as part of the employment report will now be keenly awaited.

Dollar index retreats as equity markets steady

The sense of the end of cheap money has received a reality check as investors realized that even with rate hikes; expected in the U.S., being avoided in the Eurozone and threatened in the UK, their cost of funds will remain well below historical averages for some time to come.

The correction that has been seen recently in equity markets was just that and not driven by any economic downturn. In fact, in the U.S., the opposite is true as the economy starts to grow a something close to trend which will require higher rates should inflation start to pick up

The dollar index retreated from its high of 90.56 seen last week as risk appetite returned albeit in a less frenzied manner.

The Euro held above medium term support at 1.2210. That will now concern ECB President Mario Draghi whose “benign neglect” of any comment that could be supportive to the single currency had seemed to be working. It has now reached a high of 1.2320 and looks set to resume its rally.

Tomorrow’s release of inflation data in Germany will give some indication of the level of inflation across the entire region which is due for release at the end of next week. Q4 GDP for the Eurozone will also be released tomorrow and a rise to 2.7% from Q3’s 2.6% is expected which will also bring pressure for higher rates.