The Emperor has more new clothes
Am I the only one struggling to find any new metaphors to describe just how bizarre I find the rise in the pound since the start of the New Year? Is it that the market got itself so short of sterling post-referendum that any good news on Brexit becomes a self-fulfilling prophecy?
It is virtually impossible that new long positions are being created on the back of the UK’s total capitulation in round one of the Brexit talks and some 'bar-room' gossip that the Netherlands and Spain want to keep the UK close post-Brexit. I am not sure what that comment even means. I have even read that Angela Merkel making progress on her own coalition is good for the UK since she is 'understood' to favour an equitable trade deal. If all these politicians are starting to turn towards a softer stance on Brexit have they told Tusk, Juncker or Barnier yet or will the tail continue to wag the dog?
So, now we know, a fall in inflation is bad for sterling. Today’s release of inflation data showed that headline price increases fell back to 3% in December. The collective sigh of relief from the MPC could be heard all over the country. Now, comes next week’s employment report where any rise in salaries and a narrowing of the gap between prices and wages will give sterling a genuine reason to rally.
Euro rally not much better
At least the reasons to buy the euro are based on something a little more tangible. Conditions are clearly turning in favour of a tightening of monetary policy no matter what the thoughts of Mario Draghi are. If this were to be the situation in two years’ time when Jens Weidmann has taken over from Sr. Draghi, the ECB would have raised rates already and the Asset Purchase Scheme would have been consigned to history.
The rally in the euro, 19% in a year will have had a considerable dampening effect on inflation throughout the region particularly in countries whose economies are not surging ahead at the rate of Germany.
Sr. Draghi remains a pragmatic Central Banker seeing the use of higher rates as a 'big stick' only to be used sparingly. This refreshing yet unusual attitude is the perfect anecdote for the region. We need to remember that the Euro is a baby still finding its feet. The economic effect of having a central bank creating monetary policy yet every member still having direct responsibility for fiscal policy despite free movement of labour is hard to reconcile and will need to be looked at. It seems Emmanuel Macron is on the case.
Oh Donald, please don’t take the credit!
The dollar index is languishing at a level not seen since 2015. It has fallen by 12% in a year. This will have an inflationary effect on the economy that will manifest itself first in a rise in producer prices. Inflation has been lacking in the U.S. economy and has been the major reason for conservation within the FOMC about rate hikes that have already taken place and those expected in 2018. The market is expecting three hikes in 2018 on top of the three that have taken place since December 2016.
President Trump has been very keen to see a lower dollar, but can he be called a currency manipulator as he labelled Germany early in his Presidency. That remains to be seen.
The U.S. economy while not racing ahead is certainly performing well and in such circumstances, the expectation would be for a stronger currency as interest rate differentials widen.