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May Dashes Hope For Brexit Deal, GBP Crashes

Published 2018-09-21, 04:15 p/m
Updated 2023-07-09, 06:31 a/m

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

In one day, sterling lost all of the gains that it had built up during the week and this shows just how sensitive the currency is to Brexit news. At the start of the month, it appeared that a deal was close but the talks broke down when Prime Minister May said they were at an impasse this week. She said they are far apart on two big issues and the UK expects respect from the EU rather than an outright refusal to accept their proposal. The biggest hang ups are their post-Brexit economic relationship and the Irish border. May sees no deal as better than a bad deal, which is bad news for sterling, especially as her own Euro-sceptic MPs want her to abandon her Chequers plan. Stronger than expected retail sales and consumer price growth were completely forgotten as investors focused on renewed Brexit uncertainty. With no major UK economic reports on the calendar in the coming week, we expect further weakness in sterling. GBP/USD should drop below 1.30 but its greatest weakness may be against the yen and commodity currencies. GBP/JPY in particular could fall below 146.

Judging from the recent performance of USD/JPY, investors are preparing for a dovish hike. The market is pricing in 100% chance of a quarter-point rate increase on September 26 and a 75% chance of tightening on December 19, but we think the risk of disappointment is greater than that. After 3 rounds of tightening, it would behoove the Fed to take a break, especially given the president’s criticism, trade war uncertainty and mixed data. Since July, there’s been weakness in retail sales, inflation, housing and manufacturing activity. However with strong corporate earnings, record highs in stocks and continued labor-market strength, if the Fed wanted to raise interest rates again, the arguments are there. As a result, we expect the dollar to consolidate with a mild bias to the downside before the FOMC rate decision. There are a handful of other economic reports scheduled for release such as consumer confidence, personal income and spending but they will be overshadowed by FOMC flows. USD/JPY in particular is vulnerable to a correction back to 111.50.

Softer-than-expected Eurozone PMIs drove the euro lower. Although service-sector activity strengthened, growth in the manufacturing sector is slowing and we think it will affect Monday’s IFO report. EUR/USD hit a 2-month high this week but it is vulnerable to a correction down to 1.1650. The Swiss franc rose to a 5-month high despite the Swiss National Bank’s growing concern about the currency. Diversification out of European currencies into the franc is the only reason that we see for the currency’s strength.

All 3 commodity currencies ended the day unchanged after strong gains this week. USD/CAD initially traded lower on the back of stronger retail sales but trade headlines prevented the loonie from extending its gains. Canadian Foreign Minister Freeland came back to the U.S. to continue talks but on Friday the White House said they are getting very close to a NAFTA deal that involves Mexico and not Canada. Every trade negotiation deadline has been blown and if they don’t reach an agreement by next week, President Trump could choose to move forward with Mexico alone because he wants a deal signed before the current president leaves office. Trade headlines will overshadow next week’s GDP report and the risk of no deal with Canada means USD/CAD could squeeze back to 1.30. Technically, there’s also a lot of support for USD/CAD above 1.2850. The Australian and New Zealand dollars consolidated their gains. No news could be good news for both currencies in the week ahead.

The Reserve Bank of New Zealand has a monetary announcement. When it last met, it sent NZD/USD tumbling to its lowest level in 2.5 years by pushing out its forecast for a rate hike from Q3 of 2019 to Q3 of 2020. This was a significant change at the time that reflected its concern about growth. Since then, we’ve seen quite a bit of improvement in New Zealand’s economy, especially in consumer spending, GDP and inflation. In the second quarter, the economy expanded at its fastest pace in 2 years. Although weakness elsewhere keeps the central bank neutral, these latest reports reduce the chance of easing by the RBNZ and increases the odds of a slightly brighter outlook by the central bank. If the RBNZ says nothing damaging, NZD/USD could squeeze up to 68 cents but if it maintains an overly cautious outlook, the pair could slide below 66 cents.

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