Bank of England fails to stem GBP decline
There is a notable risk-off tone to financial markets on Thursday, European stocks are down approx. 1%, and US indices have also opened lower. Even gold is down, albeit slightly, while in the FX space, the pound has taken a beating post the Bank of England meeting. The key themes driving the markets include: 1, a resurgence in Covid-19 infection rates in the US, China and Europe, 2, geopolitical tensions particularly between China and India, and 3, updates from the world’s major central banks.
Why second wave Coronavirus fears are not warranted, yet
Looking at the first two points, we believe a second wave of coronavirus is a very real prospect, however, fears about it leading to a second wave of lockdowns and crippling the global economy are overdone. Let’s face it, governments around the world cannot afford a second lockdown, and, on a brighter note, a second wave of coronavirus should be better contained using track and trace technology. On the back of this, we were very happy to hear that the UK government is ditching its plans for an NHS-designed track and trace system, and instead will use data supplied by Apple and Google. If, in a week or two there are no spread of cases in say Beijing or Germany, and the containment strategy has been proven to work then we could see financial markets calm down.
Until there is an effective vaccine for Covid-19, there are likely to be further outbreaks, the financial market reaction will all depend on the speed with which localities can be locked down, and how long it takes for new infection rates to plateau. Looking ahead, the greatest risk for future flare ups could come in September, if foreign travel is permissible and if Europeans fly to popular holiday destinations this summer. The outcome from this hypothetical situation is binary for financial markets: if airlines and holiday resorts can implement effective strategies to ward off the virus, then markets could rally in the next 2-3 months, however, if foreign travel leads to a broad spread of coronavirus then we could see financial markets take a sharp drop lower. For now, the current outbreaks have been limited to food processing plants in Germany and Beijing, and to the early ending of lockdown restrictions in some US states. Thus, for now, Covid should not frighten investors.
Why geopolitical fears could be overdone
The second point is about geopolitical tensions. Flare ups of this kind tend to send shivers down financial markets. However, after working in financial markets for close to 15 years, I have started to treat geopolitical concerns as part of the normal path taken on the investing journey. There are countless times that geopolitical issues have rocked markets: Iran and US tensions, China and US tensions, North Korea. Often flare ups of this kind happen a few times a year. While they are interesting from a political point of view, I do not recommend that investors get too obsessed by these events and do not factor them too closely into your trading plans. Every geopolitical tension has been diffused, so far, since I have been working in financial markets, and their ability to knock risk sentiment tends to be short-lived. I expect the same to happen this time.
The Bank of England stands ready
The Bank of England meeting on Thursday delivered the goods, an extra £100bn of bond purchases were announced, that brings the total stock of the BOE’s asset purchases to £745 bn. The bank also voted unanimously to keep the interest rate at 0.1%. the key question now is what the Bank will do next, to get an idea about this we have gone through the minutes of Thursday’s BOE meeting and condensed the most important points:
· A mixed economic picture: good signs that the economy is picking up after the lockdown, however, the employment picture remains grim. The economic outlook depends on the evolution of the pandemic, how governments and public health bodies react to any future outbreaks and how consumers respond to this.
· Future action: the MPC is committed to providing more stimulus if needed and will keep the asset purchase scheme under review.
· The UK economic outlook: even though the economy shrank by an enormous 20% in April, the cumulative fall in output across April and May, of 25%, was lower than expected. The bank also noted that there was a “substantial heterogeneity” when it came to households’ experience of the lockdown, with furloughed workers, some 11 million people, the most concerned about their economic futures.
· The Bank remains ready to act swiftly to reach its 2% inflation target. This goal is proving tricky to achieve, with May’s headline annual CPI figure falling to 0.5%. Although the minutes did not explicitly mention negative interest rates, the fact that some members would favour a “prompt response to downside (economic) risks” to ensure a return the target inflation rate, suggests that negative rates could be used down the line if inflation doesn’t pick up in June and July. This is one reason why the pound is under pressure today.
Overall, the BOE’s commitment to extending its asset purchase programme and helping the economy further has not triggered a rush to buy the FTSE 100. Other factors that we list above are driving markets right now, however, a boost to global liquidity levels are ultimately positive for financial markets, and we do think that recent weakness will be short-lived. Interestingly, the biggest gainers on the FTSE 100 include Flutter Entertainment, Whitbread and Prudential – basically a mixed bag. Investors are not heading for the exits, where there is a compelling reason to buy a company, investors are willing to step in. This suggests to us that risk appetite will return in the short term.
GBP is having a dreadful week and is down some 250 points. We hadn’t expected such a large decline, but the market seems to be pricing in the prospect of further BOE support and potentially negative interest rates down the line. The testing of the $1.24 level will be a key test of sentiment for sterling. If we see it bounce off of this important support level then we may see a recovery back to the $1.2460 level- the 38.2% Fib retracement level of today’s sell off, with $1.24 a key support level in the short-term. However, the speed of the pound’s sell off, and its broad-based nature, suggests to us that a further decline in sterling is likely as we move into the end of the week. A return to $1.23 could be on the cards.