A cliff edge for sterling, and Trump’s trade war rattles markets, again

Last week saw some impressive moves in financial markets, particularly for August. Sterling and government bond markets were particularly active. After a rout in the British currency, a swoon in global equity prices and a surge in the safety of government bond prices, the question now is, will the price action pick up where it left off last week, or have the big moves already occurred? 

Politicians meddling in markets 

Politicians on both sides of the Atlantic caused last week’s sell-off and the spike in risk aversion in financial markets. After a torrent of domestic incidents, particularly in the US, the politicians have stayed away from market talk this weekend. Will this be enough to settle markets as we move to the second week of August? In our view, the big focus this week will be the pound and where it goes next, and then US stocks, will they embark on a summer slowdown after reaching record highs? 

GBP: How low can it go? 

Looking at the pound first, the sell off last week was epic. It sunk 2% in a 22-hour period of unabated selling. Only when the currency dipped below $1.21 did some very weak buying action help to propel the currency back over the $1.21 level. Considering this time last week, GBP/USD was trading just below $1.24, this move is significant. Some have called it the third wave of the GBP/USD Brexit inspired sell off. The first one occurred directly after the referendum result in June 2016, when the pound fell by the largest amount in the post Bretton Woods era. The second came three months’ later when then Prime Minister Theresa May first touted the prospect of a no-deal Brexit. The third wave came last week, when a procession of new cabinet members declared that a no-deal Brexit was the government’s working assumption. Interestingly enough, as David Smith in The Sunday Times notes (and I can corroborate based on my years of experience in the FX market), perhaps the bulk of London’s currency traders supported Brexit, however, this does not mean that the currency gets let off the hook. A no-deal Brexit is likely to be negative for the UK economy, so says the pound’s steep decline in recent days. Boris Johnson’s half-hearted attempt to step away from a no-deal scenario at the end of last week, which helped GBP/USD to recoup 60 pips or so of the 300 pips it fell during the week, but will this be enough to settle the currency? Or, is this third phase in sterling’s sell off likely to trigger a new range for GBP/USD between $1.15 and $1.20 as we lead up to the October 31stBrexit date. 

Why Gove and Cummings at number 10 spells bad news for sterling bulls 

The economic data matters, however, politics matters more. In our view, Boris doesn’t really pull the levers at number 10. With Gove and Cummings setting the stage for both a no-deal Brexit and an election, it is hard to see the pound staging a meaningful recovery in the coming months. However, next week could see fundamental data come back to centre stage, and we would watch the service sector PMI due out on Monday, and the Q2 GDP data that is scheduled for release on Friday. The service sector PMI is expected to inch up a notch to 50.4 from 50.2 for July, which is still uncomfortably close to contraction territory. In this environment of near persistent selling for sterling, a better than expected number could have the biggest impact on the sterling market, and we may see a recovery in GBP/USD back above $1.22. It is also worth mentioning EUR/GBP, which surged above £0.91 at the end of last week, after jumping some 600 pips. This pair could also come off the highs if we get a stronger service sector PMI for the UK tomorrow. 

Is sterling about to be pushed over the cliff edge of parity with the euro? 

The GDP figure for the UK for Q2 may only have a limited impact on sterling this week, everyone is now weighing up the possibility of a recession for the UK, with the odds of a quarterly contraction increasing for Q3 this year. The Q2 figure is expected to show that growth slowed to 1.4% from 1.8% in Q1, however, any better than expected data could also boost sterling in the short term. As things currently stand for the pound, the odds of further weakness are growing, we believe that parity between EUR/GBP could become a reality in the coming weeks, as the path of least resistance is for a stronger euro. Weak economic data this week, combined with talk of a UK general election and more no-deal Brexit rhetoric from the powers that be at Westminster, may be enough to push sterling over the cliff edge of parity when it comes to the euro. 

Why stocks could be past their peak 

Stocks are also at a critical juncture as we move deep into summer markets territory. President Trump’s declaration of another 10% tariff on $300bn of Chinese goods come September, has put hopes of a US/China trade deal on the back burner. The difference with these tariffs is that they are now focussed on consumer goods. This means that inflation could pick up in the coming months, which may limit the Fed’s scope to cut interest rates down the line, which is also bad news for US stocks. The market started to price out the prospect of a trade deal at the end of last week, however the decline to 2,930 by the market close on Friday doesn’t seem large enough in our view, and there may be further selling pressure ahead. If the Chinese specify retaliatory measures at the start of this week then that may be the trigger for a further decline in US stocks, we also believe any more trade war rhetoric from President Trump could be enough to trigger another leg lower in the S&P 500 and other US indices. 

The market vs. the Fed, who will win out? 

Weaker US economic data may not weigh on US stocks this week, as it could make it more likely that the Fed will cut rates later this year. Although at last week’s meeting the Fed stepped away from pledging more rate cuts, the market is insistent that more cuts are coming. According to the Fedwatch tool produced by the CME, there is a near 50% chance of a further 25-50 basis points of rate cuts by the end of the year currently priced in by the market. This is weighing on US Treasury yields, which fell 20 basis points last week, however, it is not protecting the S&P 500 from further downside. If we see further selling in this index then 2,750, the low from early June, is the next key support level to watch. 

Dollar watch, up, up and away

Before we sign off, last week’s Fed rate cut did not stop the dollar from rallying. The dollar index rallied to its highest level since May 2015 after the Fed’s “hawkish” rate cut on Wednesday. The dollar gave back some gains on Friday, and even the pound managed to claw back some earlier losses. Likewise, EUR/USD moved away from the key $1.10 level on Friday. However, with little on the economic calendar to move this pair, any increase in the trade war rhetoric could trigger a move lower in EUR/USD this week, as the dollar benefits from safe haven status and the European economy remains sensitive to any weakness in global trade and global growth.