A healthy dose of scepticism
Today's news headlines:
- ‘Brexit hopes rise as UK and EU take a step closer to a deal’. Yesterday’s meeting between UK Prime Minister Boris Johnson and Irish counterpart Leo Varadkar has lifted hopes that a deal can be agreed between the UK and EU. Both leaders said they could see a pathway to a potential deal while Varadkar added he now believes Johnson genuinely wants a Brexit deal. Sterling had its biggest climb in seven months on the news. (Bloomberg)
- ‘Oil rallies after report of explosion on Iranian tanker’. Early Friday morning, an Iranian oil tanker was struck near a Saudi Arabian port, causing an oil spill in the process. Iranian officials have not yet commented on the event, but a local news agency believes the explosion was a terrorist attack. The international oil price benchmark, Brent Crude, surged over 2.0% on the news. (Financial Times)
Hold your horses!
Just when we thought a hard Brexit was a foregone conclusion and presumed goal of the dynamic duo, Boris Johnson and Dominic Cummings, a story has been released which hints at a workable solution between Irish PM Leo Varadkar and PM Johnson. The reaction for the Pound has been dramatic; on Thursday, Sterling experienced the single largest intraday appreciation since mid-March 2019, and 10-year gilt (UK government treasury securities) yields saw the biggest intraday rise in history.
As usual, a healthy dose of scepticism is warranted until details of the proposal are exposed to the light of day and EU negotiators/European Commission members can comment. The large increase in optimism is most probably based on the fact that Varadkar is the largest hurdle to forward progress. This is not to blame him for lack of progress, but rather to point out that he is one of the key stakeholders to a workable Ireland solution.
Taking a deeper look at relative GBP hedging costs in the Options market reveals a different picture. The cost of hedging Pound depreciation versus the Dollar for one month has dropped dramatically. In fact, it’s relatively cheaper than a hedge against Pound appreciation. Since a one-month contract covers the 31st October Brexit deadline, it indicates the market thinks the probability of a hard Brexit at the end of the month is essentially zero. For context, this is not only about yesterday’s sign of progress, but about the Benn act which would compel the PM to request an extension. Then looking out three and even six months, the story is very different. Hedging costs against Pound depreciation remain much higher than against appreciation, which suggests the risk isn’t gone, it’s just been pushed forward.
Bottom line: The rise in 10-year gilt yields suggests longer-term inflation expectations are higher. Put another way the market thinks the likelihood of the Bank of England raising rates is higher and requires more compensation for far-date maturities which are more sensitive to an increase in the policy rate’s, so-called duration risk. This move largely presumes the damage to the UK economy since 2016 is reversible in a short time frame, which strikes us as very optimistic. Even stainless steel sunk in the ocean will erode, and the longer it is left submerged, the less it will resemble its former shape when withdrawn.
Sterling’s largest rally in seven months has sent the pair above 1.2450 as London opens—the highest level in over two weeks. While the Pound has maintained its overnight gains so far, comments from EU leaders regarding yesterday’s UK-Ireland meeting may emerge today and will likely cause more volatility for the Pound. It may only take one negative headline for yesterday’s gains to be wiped out.
News of positive Brexit-related talks between the UK and Irish leaders sent the pair above the 1.13 figure overnight. With the Euro trading flat, Sterling is likely to be the main driver of the pair, especially since today’s economic data calendar is light for both currencies. Expect volatile trading throughout the day as further comments on yesterday’s meeting emerge.
Yesterday, the common currency broke above its 1.1000 resistance level for the first time in a fortnight, reaching highs of 1.1034. The pair has since settled and is likely to be supported by the big figure in the short-run. US economic sentiment data will be released this afternoon and may bring some intraday volatility for the pair.