UK PM Johnson today gave an impassioned speech, in which he set out an ambitious recovery plan for post-Covid-19 Britain.
Johnson, claiming he had been inspired by US president Franklin D Roosevelt (who led America out of the Great Depression with his New Deal in the 1930s), promised huge investment in infrastructure and a return to his “leveling up” agenda, which was much of the focus of the 2019 election campaign. Given that Johnson promised not to raise taxes or reduce spending elsewhere, one would assume his plans will be financed by the issuance of debt (he noted that, given low rates at the moment, now is a good time to borrow).
GBP seems to have responded positively to the speech. GBPUSD is back above 1.2300 and sterling is today’s G10 outperformer. Do note though that none of the spending pledges made today go above what was outlined in the March budget, so perhaps GBP upside is more of a result of month/quarter end flows (GBP has performed poorly both on the month and o the quarter.
Indeed, most analysts agree that GBP remains highly vulnerable. Two key themes are being cited…
1) UK/EU trade negotiations
The official deadline for the UK to ask for an extension on the transition period was today. UK government officials had for months repeated that they would not ask for an extension, as such, today passing with no extension should not come as a surprise. But it is still symbolic; now the pressure is on for the two sides to reach a deal by the end of the year (although most think that the EU would be willing to grant an extension at the last minute if the UK asked for one).
A month of intensified, face-to-face talks have now commenced. Sticking points such as level playing field and fisheries remain, although there have been some more positive sounds in recent weeks that the EU may be willing to soften its line somewhat on these issues.
The next month will be crucial for the outlook for GBP; should talks begin to show signs of making progress, then this could provide a BIG boost to sterling. Conversely, should the two sides remain at loggerheads, then GBP is at risk of further downside.
Indeed, ING note that, though “a fair degree of risk premia is currently priced into sterling - around 4% according to our short term EUR/GBP financial fair value model”, risk premia has not yet reached levels seen last August (the last time when no deal fears really began increasing) – back then, it was about 5%.
Note: higher risk premia = lower GBP, so pretty much, ING are saying that GBP has room to fall further, if the perceived probability of a no deal exit continues to rise.
2) Negative rates from the BoE
Money markets are currently pricing a policy rate below zero in early 2021.
ING note that “unless the UK-EU trade negotiations surprise on the upside (which is unlikely in summer months), there will be little impetus for the market to change the probability distribution of the negative rates outcome. This, in turn, means limited room for a GBP rally.”
What they are saying is that, one source of GBP upside would be if money markets started to reduce the probability of negative rates next year, but this is unlikely to happen.
I would go further in suggesting that money markets might price in a higher probability of negative rates next year if the current trend of bad UK data/lack of UK/EU trade negotiation progress continues.
As to the Bank of England, they have refused to take the prospect of negative rates off of the table, with the bank currently conducting a review of the impact of negative rates that is touted to last into H2 2020.
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