By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
The biggest story in the financial markets on Thursday was sterling‘s meltdown. The British pound dropped nearly 2% intraday as Prime Minister May’s Brexit deal dissolves into flames. The situation is still evolving but what we know so far is that the UK’s top Brexit negotiator Dominic Raab resigned in opposition to May’s intensely negotiated withdrawal agreement with the European Union. This means that while the draft deal has the support of the EU, it doesn’t have the support of her own government. In his resignation letter, Raab said he “cannot in good conscience” back the proposal because the regulatory regime for Northern Ireland poses a serious threat to the integrity of the UK and because he “cannot support an indefinite backstop arrangement, where the EU holds a veto over our ability to exit.”
At this stage, it will be almost impossible for the deal to be approved by Parliament because the concerns raised by Raab are issues shared by many members of the government. This is not only a major setback for Brexit, but MP Rees-Mogg’s call for a no-confidence vote could also spell the end of May’s role as Prime Minister. Political troubles are never good for the currency but in the case of the UK, GBP/USD could drop to 1.25 on the prospect of a no-deal Brexit, leadership challenge and slower growth. Adding salt to the wound was significantly weaker retail sales, which instead of improving, fell for the second month in a row by -0.5%. So unless May can magically convince Parliament to approve her draft withdrawal agreement with the EU, sterling is destined for more losses.
The UK’s troubles extend far beyond Britain’s borders. A disorderly Brexit benefits no one, including the Eurozone. On a day when currencies such as the Australian and New Zealand dollars are up sharply, the euro should be trading up as well. However it dropped to a low of 1.1270 on an intraday basis and ended the session marginally higher. The only reason why the euro is not at 1.12 is because of EUR/GBP, which was up 2% Thursday. The Eurozone’s economy was on shaky footing before the latest Brexit troubles, with investor confidence weakening and the region’s trade surplus falling short of expectations. Add to that a no-deal Brexit, equity market losses and lower oil prices and the case for ECB policy normalization weakens significantly. Although we still see the central bank ending asset purchases in December, it may be forced to lower its inflation forecasts. Technically, higher highs and higher lows point to a recovery for euro but we don’t see a meaningful rebound as long as GBP/USD continues to fall.
Uncertainty in one of the largest financial centers in the world is also problematic for risk appetite. USD/JPY was under pressure for most of the NY session despite a stronger Empire State manufacturing index and better-than-expected retail sales. Consumer spending grew at its strongest pace in 5 months. However a large part of the increase was due to gas prices and the need for building materials after the Hurricanes. Excluding auto and gas, spending rose only 0.3%, which is still an improvement from zero growth last month. USD/JPY managed to recover by the end of the day as equities came off their lows but that happened well after the London close. Looking ahead, Friday’s industrial production report isn’t expected to have a significant impact on the currency so the focus for USD/JPY will be risk appetite and equities.
All 3 of the commodity currencies traded higher against the greenback Thursday with the Australian dollar leading the gains. Stronger-than-expected labor-market numbers reinforced the Reserve Bank’s optimism. More than 32k jobs were created in October with labor-market gains in September revised higher. Full-time job growth was particularly strong and while part-time jobs fell, the participation rate increased. AUD also benefitted from the Chinese yuan, which increased on the back of China’s written response to the U.S.’ call for trade reforms. AUD/USD is poised to break 73 cents on its way to a new 2-month high. No data was released from New Zealand overnight but NZD/USD hit a 3-month high on the back of positive A$ flows. Manufacturing PMI numbers were scheduled for release Thursday evening and given the recent trend of NZD data, we expect a stronger release.
After climbing to a 3-month high on Wednesday, Thursday’s decline in USD/CAD was the strongest one-day pullback that the pair has seen this month. It says a lot for the loonie’s resilience when it refuses to fall despite softer data and tumbling oil prices. Lower existing home sales and house prices had virtually no impact on the currency. Although the gains in the loonie can be attributed to the recovery in crude prices, Western Canada Select, which is what really matters for CAD, dropped to its lowest level in 4 years. Canadian bond yields also tumbled more than 3bp, widening the spread against the loonie. Once again, it says a lot for the currency when it can appreciate in the face of all of these pressures and the only legitimate reason is the improvement in risk appetite. Technically, USD/CAD could extend its slide to 1.3100 but the uptrend will remain intact until oil prices stabilize.