News & Analysis

The US dollar continued to dominate price action in FX markets last week as US lawmakers wrangled over the composition of the fiscal stimulus package, while the labour market continued to deteriorate due to tightening lockdown measures in some states.

The Federal Reserve managed to stabilise the dollar on Wednesday as it stuck a more optimistic tone than many expected with respect to its economic projections, while markets also enjoyed fresh forward guidance on the QE programme. The Fed will now continue to increase its asset purchases at $120bn a week until “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” Outside of the US, Bank of Canada Governor Tiff Macklem highlighted yet again that the Bank of Canada is keeping a close eye on USDCAD. His commentary this time was the most explicit out of recent communications as he stated that the strength of the loonie is weighing on the competitiveness of Canada’s exports to the US. The Bank of England was the only other major central bank to alter things ever so slightly this week as it highlighted its willingness to provide further stimulus in the event of a negative Brexit outcome.

This week, the data calendar is much lighter after last week’s dump of central bank meetings as markets begin to wind down for Christmas on the 25th. However, a few things still need to get wrapped up before the big day. Firstly, Brexit talks are yet to conclude as sentiment around a possible deal continues to shift.

Markets are looking for a clear sign before they break for Christmas whether the UK will leave with a narrow free trade agreement or on WTO trade terms.

Volatility in the pound over the coming week is likely to provide a bang before any crackers are pulled. Secondly, fiscal stimulus talks in the US are year to bear fruit. With an estimated 12 million workers facing an unemployment cliff on December 26th according to The Century Foundation, due to the unemployment benefits under the CARES Act expiring, markets will keep a close eye on developments in Washington up until Christmas. Finally, the Central Bank of the Republic of Turkey (CBRT) are to announce their latest policy decision. The shift towards more a more orthodox monetary system has been conducive for the lira rally, but the pressure remains on the CBRT to meet market expectations with its hiking cycle.

 

CALENDAR

Monday – 21/12

Markets are unlikely to be focusing on economic data at the start of the week. Instead, they will keep a close eye on political developments over the weekend in the form of Brexit and US fiscal stimulus, with the weekend’s developments likely to drive sentiment for the whole week given how close both respective deadlines are. That being said, the Peoples Bank of China are set to release their latest 1Y and 5Y Loan Prime Rate decision at 01:30 GMT, with expectations suggesting the central bank will keep the fixing used for banks reference when pricing loans to companies and mortgages on hold at 3.85% and 4.65% respectively. The Swiss National Bank’s sight deposit data for the week of December 18th is then released at 09:00 GMT. The data point in itself doesn’t normally draw too many observers in normal times unless the franc is trading at sensitive levels, given that sight deposit data are a timely estimate of SNB FX intervention. But given the latest decision by the US Treasury department to label Switzerland “currency manipulators” and the SNB’s reaffirmation that it will still intervene in FX markets when needed, sight deposit data will be back in scope for markets. While the Treasury department’s decision is mostly symbolic as it does not lead to any punitive action unless negotiations yield results within a year, the upcoming actions by the SNB will prove key to whether the label is dropped in the Treasury’s next biannual report.

Tuesday – 22/12

Norway’s unemployment rate for October is due at 07:00 GMT and is expected to remain flat at 5.2%. Data on unemployment and consumer confidence thus far in Q4  suggests the downturn will be sort-lived and Tuesday’s data point may not include the full effects of the tightening of lockdown measures in late October. The focus then shifts to the final readings of Q3 GDP in the UK at 07:00 GMT and then the US at 13:30 GMT. Both are expected to remain unchanged from the second readings of -9.6% YoY and 33.1% QoQ annualized. Given this, and the fact that economic conditions have deteriorated substantially since, markets are unlikely to focus too heavily on these data.

Wednesday – 23/12

Unlike Tuesday’s final readings of GDP in the UK and US, Canada’s October GDP reading at 13:30 GMT will be in focus for markets. Not only is it a more timely estimate of economic activity, but the data also comes with a flash estimate of November’s release. With lockdown measures tightening in Ontario and Quebec in over these months, the impact it has on growth will be of high importance to both market players and policymakers.

At the same time, US initial jobless claims data is released at 13:30 GMT and will give markets the last estimate of the damage the third wave has inflicted on the US labour market.

The impact this will have on price action will depend on whether fiscal stimulus has been passed by then or if unemployment protection under the CARES Act is set to expire on December 26th.

Thursday – 24/12

Markets are likely to wind down in the afternoon session on Christmas Eve, but before doing so, the CBRT are set to announce interest rates at 11:00 GMT. The introduction of Governor Agbal has boded well for markets, as the shift back to a more orthodox monetary policy system gives clarity to investors. See below for more commentary on the CBRT.

 

TRY

TURKEY SET TO DELIVER ON CHRISTMAS EVE

With markets winding down for Christmas, the Central Bank of the Republic of Turkey (CBRT) is expected to meet market expectations and deliver additional interest rate hikes. After hiking rates by 475bps back in November, newly appointed Governor Naci Agbal only increased the effective interest rate in Turkey’s monetary system by a minor increment after his predecessor opted to raise interest rates by adjusting liquidity conditions. While the level of the interest rate hike was therefore small, the policy decision did bring back much needed clarity into the monetary system, as we wrote back in November. With markets now receiving clarity that the one-week repo rate is again the de facto policy rate, all eyes are on how large the interest rate hike will be on Thursday, especially given the aggressive jump in inflation witnessed in November’s data.

The CBRT has made repeated commitments to lowering the inflation channel since the introduction of Governor Agbal back in November. With headline CPI jumping by over two percentage points in November from 11.89% to 14.03%, on the back of exchange rate pass through and a rise in energy prices, the emphasis is now on the CBRT to signal its intentions clearly to market participants. The median expectation given by market participants to Bloomberg suggests a 150bps hike is incoming, bringing the one-week repo rate up to 16.5%. This is a reasonable assumption given the rise in inflation and would result not only in Turkey’s real interest rate remaining positive, but also signaling a clear commitment to markets that the CBRT is fully committed to promoting a disinflationary channel and driving CPI back into single digits. Should the CBRT not meet market expectations, fireworks could be released on Christmas Eve.

 

November’s rise in inflation puts the emphasis on the CBRT to deliver on Christmas Eve

 

GBP

DEAL OR NO DEAL: A CHRISTMAS SPECIAL

The popular UK game show “Deal or No Deal” was cancelled in December 2016, giving politicians on both sides of the English Channel a brief transition period to prepare for the next four years of providing similar entertainment. Nonetheless, negotiations have continued in a similar vein to the cancelled show over the following years, with a final deal remaining elusive as of the time of writing this note. Sterling has flipped back to “buy the rumour” mode this week after Boris Johnson and Ursula von der Leyen had a phone call last weekend and agreed to continue negotiations, and the latter said there was a “path” to a deal on Monday. Since then the stream of vaguely encouraging comments and anonymous briefings have supported a powerful sterling rally that has lifted GBPUSD to its highest levels since 2018. The highs are less inspiring against the euro, which has been enjoying its own substantial rally against the dollar this year.

Dissecting the likelihood of a deal is beside the point at this late stage of negotiations; our view remains a narrow deal is more likely than not. However, a brief review of the sticking points and possible sterling reactions remains relevant.

State aid and fisheries remain the final sticking points…

It was reported this week that both sides had agreed in principle for a mechanism for applying tariffs should one side loosen level playing field restrictions. Reportedly, the EU was previously insisting on the unilateral right to do so – unusual in trade negotiations. Fisheries appear to be the more serious roadblock of the two.

A statement from Downing Street yesterday said that:

The UK could not accept a situation where it was the only sovereign country in the world not to be able to control access to its own waters for an extended period and to be faced with fisheries quotas which hugely disadvantaged its own industry.

A close reading of this sentence reveals that neither the possibility of loss of control for a brief period of time, nor the prospect of fishing quotas, were excluded. An optimistic assessment would therefore be that the two sides are haggling over the length of any fishing transition period, and over respective quotas for cod, herring, and other fish that represent tiny proportions of the UK and EU economies.

HOW WILL STERLING REACT?

Sterling’s price action over the last week suggests markets have at least modestly updated their expected probability of a deal being struck. Unlike in 2019, there are no reliable, liquid betting markets for a no-deal outcome, so the impact of no-deal on sterling is harder to judge objectively. From March to October 2019, a simple OLS model with the market-implied probability of no deal as the independent variable, and GBPUSD as the dependent variable, returns a coefficient of -0.002. That is, every 1% increase in the probability of no-deal was associated with a roughly $0.002 fall in GBPUSD. Put another way, a no-deal Brexit would see this probability rise to 100, and cause a decline in GBPUSD of 20 cents assuming a baseline 0% probability of no-deal. For example, GBPUSD would fall from 1.40 to 1.20, assuming the starting point was a market that expected 0% chance of no-deal. This is not a rigorous quantitative model of no-deal risk and sterling exchange rates, but is a starting point for a rough rule of thumb.

 

Market implied probability of no-deal traded in tandem with GBPUSD over 2019.
Market-implied probability of no-deal is on the right hand axis, which has been inverted. GBPUSD is on the left axis

Assuming the market is currently pricing no-deal risk as a less than 10% likelihood, the removal of this risk via the announcement of a deal would, by our rule of thumb, be associated with a roughly $0.02 rally. Expressed in percentage terms as a rally from current GBPUSD levels around $1.3550, this would be around a 1.5% boost for the pound to levels around 1.3750. Conversely, a sudden no-deal come Monday would be associated with a fall of 18 cents from current levels, to around $1.17.

Naively relying on a simple (or complicated) model for making judgements about financial markets is folly. Importantly, the relationship between no-deal risk and sterling exchange rates has been non-linear and varies through time, as the model’s residuals show. Many other variables impact FX. So the rule of thumb could be blown out the window by a particularly dramatic event, or the estimate itself may be baised. Furthermore, FX markets have a tendency to overshoot fundamental developments – so a “relief rally” if a deal is struck may take sterling far higher than the rule of thumb indicates. Finally, markets may be “pricing” a higher probability of no-deal than our subjective 10% number, and thus implying a bigger relief in the event of a deal being announced. Investment bank JP Morgan estimates the probability at 30% for example. Despite these caveats, this simple example illustrates some possible assumptions for how sterling will behave in the event a deal is announced.

Our subjective judgement remains that the announcement of a deal is likely to lead to a 1-4% rally for sterling, while a sudden no-deal outcome would lead to losses in the order of 4-8%.

 

Simple OLS model with GBPUSD as the dependent variable, and the market-implied probability of no-deal as the independent variable.
GBPUSD on right hand side, residuals of model on left hand side – note the residuals are very poorly behaved. This is an illustrative example intended to serve as a rule of thumb, not a rigorous quantitative model of these two markets.

 

Authors: 
Ranko Berich, Head of Market Analysis
Simon Harvey, FX Market Analyst

 

 

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