By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Sterling dropped like a rock after Bank of England Governor Carney said another rate cut is coming this summer. Carney has always been nervous about how Brexit would impact the U.K. economy and now that it's a reality, he is preparing for the worst, agrees with the doom-and-gloom scenario and wants to assure the market that the BoE will be proactive. Aside from saying that “some monetary policy stimulus” is likely to be needed over the summer, Carney also warned that the BoE can react more rapidly than other institutions and that the central bank will have its first full projections in August – which means we’ll be looking for a move around that time. Not only has GBP/USD dropped back to the 1.32 handle, but 10-year U.K. gilt yields also fell to a record low.
The other big news in the U.K. came from Boris Johnson, who will not be running for Prime Minister. He was a strong contender and by removing himself from the leadership contest, he adds to the U.K.’s political uncertainty. Theresa May is now the favorite and she wants to respect the vote to leave the European Union and is in no rush to invoke article 50. According to her recent comments, “There should be no decision to invoke article 50 before the British negotiating strategy is agreed and clear, which means article 50 should not be invoked until the end of this year”. Throughout this week we spelled out all of the reasons why sterling will resume its slide and we continue to view Brexit as the greatest uncertainty for the U.K. and global economy. The U.K. PMI manufacturing report is scheduled for release Friday and even though the sharp improvement in the CBI index points to stronger activity – the positive impact on sterling should be limited.
The Bank of England’s plans to ease monetary policy was positive for risk appetite and led investors to think that other central banks will follow, causing the focus to shift to the ECB after a Bloomberg report that it could weigh loosening its QE rules. This was later denied by an ECB press officer but considering that the pool of debt is shrinking as Bloomberg explains, there’s merit to this report. It also puts the thought of easing into the market's head going forward, which means that traders will be looking for dovish comments and a possible move from the ECB that would validate a short trade. Any denials will be viewed with skepticism. Meanwhile, data was better than expected – German retail sales rose 0.9% in May, which was much stronger than expected while German unemployment rolls fell 6K, leaving the jobless rate at 6.1%. The euro is taking its cue from sterling and while it received a bit of support Thursday from EUR/GBP demand, we are looking for a move below 1.10.
The U.S. dollar traded higher against most of the major currencies on Thursday as everyone else’s problems make U.S. assets more attractive. The latest U.S. economic reports were also better than expected. Jobless claims increased, but less than anticipated, while the Chicago PMI index rose to its strongest level since January 2015. All of this bodes well for Friday’s ISM manufacturing report, which is likely to show manufacturing activity rising across the nation. The focus turns to the labor market next week with nonfarm payrolls scheduled for release. Everyone is hoping for a big rebound after last month’s abysmal disappointment but strong job growth in June won’t be enough to counteract risks posed by Brexit and put the Fed any closer to raising interest rates this year.
According to the Ministry of Finance, there was no foreign-exchange intervention last week so the 200-pip rally over the course of 2 minutes the evening after Brexit was not official action. Instead, it is now obvious that the quick reversal was triggered by automatic buy orders below 100 and short covering or profit taking around that key level. The market clearly thinks that 100 USD/JPY is the line in the sand for the Bank of Japan but even at 102, we see policymakers growing concerned about exchange-rate volatility. Recent Japanese economic reports have also been very weak with the trade balance returning to deficit in May, retail trade growth falling by the largest amount in 15 months year-over-year and industrial production contracting -2.3%. If Thursday night’s Tankan report (manufacturing, non-manufacturing) shows further weakness, USD/JPY could hit 104.
The yield premium offered in Australia and New Zealand has become more attractive with the dovish rhetoric from the BoE, but Australian and Chinese PMIs were scheduled for release Thursday evening and these reports could potentially scuttle the rally. The Canadian dollar failed to participate in the move despite an uptick in GDP growth because the oil price resumed its slide. Canada’s economy expanded 0.1% in April, which helped to lift the year-over-year rate to 1.5%. Inflation is also on the rise with raw-material and industrial-product prices jumping in May.