Today marks the sixth anniversary since the Brexit vote, which triggered a significant surge in uncertainty that has been weighing on the economic activity. UK switched from being the best-performing economy in 2014 among the G7 to one of the weakest-performing economies in recent years. The UK is expected to be the worst-performing economy next year among G20 (after Russia) following the recent significant downward revision by the OECD, from 2.1% to 0%.
Hence, the stagflationary environment should continue to weigh on the British pound, which remains ‘cheap’ but very risky. In addition, the risk off sentiment driven by the geopolitical uncertainty and the sharp tightening in financial conditions (surging ST rates) leave equities vulnerable in the near term, which could also impact Sterling quite significantly.
Historically, the pound has been the most sensitive currency to high-volatility regime; periods of sharp drawdowns in equity markets are generally associated with aggressive pound selloff. For instance, Cable plunged from 1.32 to a low of 1.1412 during the March 2020 market panic.
The chart below shows the strong co-movement between GBPUSD and EM equities in the past 6 years (since Brexit), and therefore further retracement in equities (amid lack of visibility and convictions) leaves Sterling vulnerable in the near term.
Figure 1: GBPUSD vs. EM Equities(source: Bloomberg)
Last month, we wrote an article that summarized all the decision made by the US policymakers since GFC and the impacts as soon as the central bank was stepping out of the market (see article Could we survive without QE?)
We concluded that as soon as the Fed was ‘leaving’ the equity market and let it rely on fundamentals only, we saw sharp correction straight afterwards (See chart below: April—July 2010, July – August 2011, September-November 2012).
As we are ‘kindly’ approaching the last days of QE with the Fed stepping out of the bond’s market at the end of this month (October 28th), we thought it is a good time to give you an update on the current situation. And Guess what: this time is not different. Since the mid-September high of 2,019.26 (Sep 19th), the S&P 500 is down 7 percent and closed for the second consecutive session below the 200-SMA for the first time since November 2012. And the question we are asking ourself is: how far it could go? We don’t have a specific answer to that, but what we can tell you is that the Fed’s Officials are now realizing their mistake by expressing themselves on their ST monetary policy. Our thoughts have always been that Yellen [& Co.] should have let the market swallow a period without QE before considering raising its ST interest rate. Therefore, we saw at the last minutes (last Wednesday) a different tone, with policymakers suddenly jawboning about the US Dollar Strength (Yes, even the Fed is not comfortable with a strong exchange rate) and the fact that global slowdown could rise risks to US outlook. We expect the tone to remain neutral until the end of the year, therefore capping the appreciation of the US Dollar against all currencies. If the equity market continues to tumble, we think we can even see/hear a couple of dovish statements/conferences as the equity market is one of the most important index (with oil) for US policymakers.
If we have a look at the LT interest rates, the 10-year US yield is now trading at its 18-month low at 2.20%. Clearly, that shows the situation in the market is much more fragile than expected. Moreover, we added a similar chart as the S&P 500 but this time applied to the 10-year yield. We read and heard analysts’ recommendations on yields, and most of them are quiet bearish on Treasuries in the next months to come, targeting a 10-year yield at 3%. However, if we look at the chart below, we can see that each time the Fed stepped back of the bond market, LT yields contracted (March – November 2010, July-September 2011). And it looks like this time is [also] not different with the 10-year yield down 80bps since December’s Taper Announcement.