No surprises for guessing where all and sundry expect the volatility to come through this week as the Brexit circus rolls out the main acts starting with the meaningful vote on Tuesday evening. Sparing the rundown on what to and what not to expect, the plethora of coverage makes it pretty obvious that either parliament votes for the current deal or we effectively decide on ruling out a no deal and ensure a soft quasi Brexit. Do the probability of outcomes warrant a material drop in the Pound at this stage? We would suggest not, as it is clear both sides will suffer in a no deal scenario and anyone keeping tabs on parliament will see there is a majority to reject this – irrespective of how this impacts on the UK’s negotiating leverage. Our base case scenario is that – albeit at the 11th hour – one or both sides will avoid the worst of possible outcomes.
From a purely technical perspective then, we look to the 1.2850-1.2950 zone as a significant area which should define whether we could see an early base forming, so soon after 1.3000 gave way last week. We anticipated a little more support ahead of this psychological level, but late week/pre-weekend fear and jitters gave Sterling little chance of stability in this context. We maintain price action and the time zones they trade in have a strong bearing on where and how far levels can be stretched. It abundantly clear that traditional technical analysis is losing touch with the modern day trading patterns.
From a fundamental perspective, EUR/GBP perhaps confounded many with the way it pushed higher on Friday, so soon after the dovish actions by the ECB sent the EUR down through cycle lows to test the 1.1175-1.1200 area vs the USD. EUR/USD is now widely expected to test towards 1.1000 over the coming weeks, though we will need to contend with further support in the low 1.1100’s to challenge this pivotal level. Given its historical relevance, we would argue that only the prospect of an existential Eurozone crisis will drive the EUR below here.
From current levels, we will need to assess how the medium term outlook develops in the key member states, with Germany’s economy having caused justifiable concern as its manufacturing PMIs remain below the 50.0 mark. Only this morning, we saw industrial production falling 0.8% in Jan, as well as its trade surplus narrowing once again.
In the current climate of fragile global demand, all export-reliant regions are undergoing testing times, and US-European trade tensions are still lingering in the background. This may be alleviated for a temporary period if US talks with China can yield positive results, as we expect some presumptuous follow through into the EUR. For now, trying to establish a base in EUR/USD is not only premature but also offers little prospect on the upside based on the economic climate at present.
Optimism over a US-Sino trade deal was reinforcing the carry trade up until the middle of last week, after which time the cumulative impact of central bank caution (heightened by the ECB) led to a brief fallout in risk assets. This seems to have stabilised again with Wall Street equities grinding higher again pressing on the JPY once more.
USD/JPY managed to hold off a resistance area capped by 112.30-35 last week, which may well serve as a longer-term top, but as long as 110.25-30 holds firm on the downside, we expect flights to safety favouring the USD to some degree, which will continue to takes out a large tranche of volatility in this pair.
There is also a lack of response to a softer tone from the Fed, which as is now widely acknowledged as a positive backdrop for risk assets in DM. It is our belief that the only real catalyst for a sharper move in USD/JPY is likely to come from any tapering expectations from the BoJ, who at present, stick to their ultra easing bias though global asset purchases.
The commodity-linked currencies seem to be drawing little inspiration from broader sentiment, with dovish turnarounds from the RBA and BoC proving to be the ultimate driver for AUD and CAD respectively. The traditional correlations have been sporadic, to say the least, but we can see little respite for the AUD as long as fears over China’s slowdown persist and the how slowing demand will eventually impact on Oil prices and the Canadian economy. The BoC made a point of citing caution on activity and output based on the outlook for Oil prices ahead. CAD buyers are likely to be tempted in should we see a spike above 1.3500, but at this stage, broader themes have not ruled out a stronger move towards the 1.3600-1.3800 region as yet.
AUD/USD set out its parameters at the start of the year by hitting levels in the mid 0.6700’s, and at some stage, we expect a move back to test these levels if/when China’s slowdown gathers prominence again. After the recent stimulus measures from China, we would have expected a stronger response from the 0.7000 area, but the reluctance perhaps tells its own story. 0.7120-0.7170 is a region we are keeping an eye on, but the lack of momentum suggests this area will contain trade unless we get a material turn in the US data.
USD prominence continues to highlight, or more so reflect the lack of viable alternatives at present, though net exposure is making for a challenging environment in G10 FX as USD strength also has its limits. Markets are pricing in a flat year at the Fed, and this is consistent with our view. Policymakers still believe there is scope for another hike this year and next, but only significant wage inflation will force their hand against a sensitive equity market.