Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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FX Update: Hard Brexit fears dominate the FX focus
John J. Hardy
Chief Macro Strategist
Summary: Sterling is stealing the spotlight among major currencies as the market is scrambling to position for hard Brexit risks on the latest hostile exchange between the UK and the EU. As for the ECB meeting yesterday, the euro tried to rally on the more sanguine language from Lagarde and company, but by the end of the day the market decided it was a non-event.
Trading focus:
All about sterling as market scrambles to price Hard Brexit risks
GBP is collapsing and if we are really headed toward a hard Brexit, there is more downside potential to price in.
The sterling price action has gotten downright brutal as market participants scramble to position for Hard Brexit risks on the latest exchange between the UK and the EU. The latter issued a three-week ultimatum for the UK to back away from its drawing up of plans to override portions of the withdrawal agreement and threatened legal action. The UK shrugged off this push from the EU and neither side produced any language that was remotely hopeful. GBPUSD six-month implied volatility for options has risen close to 11.5%. Besides the chaotic high in March during the COVID-19 panic, this compares with highs around 12.0% during the hard Brexit fears about a year ago before the withdrawal agreement was drawn up and almost 14% in the late 2018 stand-off. The situation is as serious as it has ever been because this time we are finally talking about the actual reality on the ground for the UK post-Brexit that will prevail in less than four months. Will realpolitik prevail and the two sides hammer out an amicable agreement, or is this a fight on principles that means both sides are willing to suffer significant damage to defend their principles: the UK on its sovereignty and the EU on ensuring the UK doesn’t enjoy advantages not available to its own members? I fear the latter.
Chart: EURGBP
EURGBP has ripped to a new post-COVID-19 panic high after yesterday’s developments and we could see further repricing of GBP to the downside as long as the stand-off persists. Both sides will take a hit in the event of a truly hard Brexit, with the economic hit to the UK far harder and requiring a far greater mobilization of fiscal and monetary stimulus to offset for the damage – which would bring with it fears of more deeply negative real rates in the UK, akin to the fears that have driven the USD lower. For now, one eye on headlines and the other on the 0.9150-75 pivot area broken in EURGBP on the way up and then on the COVID-19 panic highs into 0.9500+. Let’s recall that the reaction to the Brexit vote back in 2016 only took EURGBP as high as 0.9415.
ECB takes euro nowhere in a hurry
The ECB meeting triggered a steep rally in the euro yesterday as the earlier reports from sources suggesting that the ECB is not terribly concerned about the euro at these levels and is a bit more sanguine on the economic outlook were confirmed. The EURUSD rally failed later in the day as the USD fought back on weak risk sentiment and underlines that the rally was not built on game-changing developments. As well, as I noted during the Lagarde press conference yesterday – should we really be bidding up the euro aggressively when at the same time we have the market panicking to price in escalating risks of a hard Brexit in the background? It’s difficult to quantify to what degree yesterday EURUSD rally reject was down to sterling’s woes. Regardless, the EURUSD technical situation remains in limbo after the pump-and-dump action yesterday – still needing to prove itself with a downside break below 1.1750 at minimum after yesterday’s shooting star candlestick. This morning, ECB Chief Economist sounded a bit less complacent in an ECB blog entry in which he opined that “the recent appreciation of the euro exchange rate dampens the inflation outlook “. Elsewhere he stated that “it should be abundantly clear that there is no room for complacency.”
US August CPI on tap - higher stake than usual.
Today’s August CPI possibly offers an interesting test of the narrative driving the USD lower over the summer, the idea that negative real rates in the US on massive money supply growth and higher inflation rates will see the US at the bottom of the pack in the erosion of its currency’s purchasing power. A significant upside surprise is the most USD negative, while a big downside miss would likely mean USD strength. Technically, the USD selling has faded, but hasn’t yet bounced enough to point to a more notable consolidation effort higher. A weak CPI reading and/or a powerful additional wave of risk off that finally washes over global market and not just the volatile US equity market are the possible ingredients for a tactical USD comeback.
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