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Brexit Fallout Worsens, Sterling At 30-Year Low

By Kathy LienForexJul 05, 2016 15:42
ca.investing.com/analysis/brexit-fallout-worsens,-sterling-at-30-year-low-200139880
Brexit Fallout Worsens, Sterling At 30-Year Low
By Kathy Lien   |  Jul 05, 2016 15:42
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By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

So much for summer doldrums – the bears came charging out at the start of the third quarter, sending sterling to its weakest level in 31 years. We saw investors flock into the safety of U.S. dollars as the liquidation spread to stocks, commodities, the euro, Australian and Canadian dollars. Oil prices dropped 5% as 10-year Treasury, Gilt and Bund yields hit record lows. The only market rising are U.K. stocks and that’s only because sterling is falling. U.K. investors are finally waking up to the harsh reality of their country’s decision to leave the European Union. And mark our words, the dominos have only began to fall.

Tuesday's big story was the decision by 3 major U.K. property funds to suspend redemptions – Aviva (NYSE:AV), the U.K.’s largest insurer, Standard Life (LON:SL) and M&G Investments. Since Brexit, we’ve seen property stocks plunge – the U.K. property market has been a longtime favorite of foreign investors but Brexit uncertainty caused many investors to drop out of deals or rush to list their holdings. Right now we have just started to see the value of property funds and REITs fall but in the coming weeks and months, Britons will start to see their property values decline, creating greater reasons for consumer retrenchment. There’s no question that Brexit puts significant stress on the financial sector and property funds are only the first to feel the pain. Other sectors will start to implode, creating greater pressure on the U.K. economy and British pound.

The Bank of England hasn’t missed a beat – it took the first step Tuesday to limit the shock on the economy. The Financial Policy Committee cut the capital requirements of banks, freeing up 150 billion pounds to encourage lending. It also signaled that further actions if appropriate can be taken to support financial stability. This is Carney’s way of showing the market that he won’t be passive if things worsen -- and they will. Carney’s made 3 appearances in the 12 days since Brexit and there’s been no sugar coating. He’s long felt that Brexit poses a significant risk to the economy and is now taking every opportunity to reassure investors that BoE will provide leadership in time of uncertainty. So we are looking for additional easing measures from the central bank as quickly as August. Aside from lowering interest rates, there could also be a sizable boost to the QE program. GBP/USD bounced off 1.30 Tuesday but fundamental factors could drive sterling down another 3% to 5%.

The U.S. economy has its own problems with the latest string of economic reports surprising to the downside but its troubles pale in comparison to Europe’s, which is enough for most investors. The greenback traded higher against all of the major currencies today with the exception of the yen. USD/JPY has a very strong correlation with U.S. yields and the fresh record low in 10-year rates took the pair below 102. We suspect the Fed is growing worried about the stronger dollar and the stress on the financial markets. Manufacturing activity reports are beginning to turn negative with factory orders falling 1% in May and durable goods orders revised down to -2.3%. Economic sentiment is also deteriorating with a survey from IBD/TIPP falling to 45.4 from 37.2. The ISM non-manufacturing index, trade balance and Fed minutes are scheduled for release on Wednesday. But if falling U.S. rates won’t stop investors from buying dollars, neither will these reports.

For the past week, EUR/USD was a big beneficiary of anti-U.K. flows but on Tuesday we finally saw the currency buckle under the weight of U.S dollar strength and risk aversion. Tuesday morning’s Eurozone economic reports were mostly better than expected with German service sector and French composite activity PMI indices ticking up. However we believe that the weakness of the euro stemmed primarily from the market’s fear that Britain’s troubles will spill over to the Eurozone, forcing the European Central Bank to return with fresh stimulus. 1.10 is the main support level to watch for EUR/USD.

The rise in the U.S. dollar also drove the Canadian, Australian and New Zealand dollars sharply lower. NZD was the worse performer, falling more than 1% after dairy prices declined slightly. The Canadian dollar was hit hard by the decline in oil and may not recover much even if Wednesday’s trade balance is better than expected. However the main focus Tuesday for the commodity currencies was AUD, which had key data, a monetary policy announcement and election fallout to contend with. Over the weekend, Australia held a Federal Election and the vote was too close to call. The ballots will need to be counted again but the Liberal/National Coalition government clearly lost their majority, which means future fiscal changes will be difficult. The Reserve Bank of Australia left interest rates unchanged and while it expressed concern about the global economy and Brexit impact, it was optimistic about domestic conditions. There was no major urgency to lower rates and this view highlights the generous 1.75% yield offered by Australia. In an environment of rapidly falling yields, it will be easy for investors to overlook softer data including Australia’s PMI services index, trade balance report and retail sales.

Brexit Fallout Worsens, Sterling At 30-Year Low
 

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Brexit Fallout Worsens, Sterling At 30-Year Low

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