Ramping up preparations
Today's news headlines:
- ‘Boris Johnson in £300m bid to shore up the Union'. Boris Johnson's plan to spend £300m to bolster the Union may lead to a difficult stand-off with Scottish Tory leader, Ruth Davidson, who may require him to back away from a no-deal Brexit. (The Times)
- 'Oil trades near $56 as Hormuz tensions simmer amid trade talks'. West Texas Intermediate, a key US oil benchmark, has fallen towards one-month lows as demand concerns—stemming from trade talk pessimism—trump supply issues surrounding the British/Iranian tit-for-tat. (Bloomberg)
Boris Johnson's newly formed Brexit Cabinet will meet today, and every day until the UK is due to leave the EU on October 31st. Michael Gove will chair the sessions as the British government ramps up preparations to leave the EU without a deal unless the bloc agrees to re-open negotiations. In recent days, Johnson has hardened his rhetoric, declaring that Theresa May's Brexit deal is dead. He has also rejected any form of backstop to avoid a hard Irish border and vowed to leave the EU on October 31st 'do or die'. The increased likelihood of a no-deal can be seen in Option pricing, where the cost of Sterling downside protection has jumped markedly. The cost of Option hedging at the Forward rate in three months has risen by about 44% in the past two weeks, and the Pound Index remains close to all-time lows.
Dominic Cummings, a key figurehead in the 2016 Brexit campaign told advisers that Brexit will happen 'by any means necessary' and that Johnson is prepared to suspend Parliament or hold an election to ensure a timely exit. Chancellor of the Exchequer, Sajid Javid, is also ready to release more than £1bn for the planning of a no-deal scenario, but neither the EU or Britain is prepared for a hard Brexit according to business lobby CBI. Johnson will still need to convey some sense of Parliamentary union to EU negotiators for them to come back to the table but, his all-or-nothing approach is certainly sending the right signals.
More room to cut
The Federal Reserve risks inflating price bubbles by cutting interest rates this week as US assets reach all-time highs. US economic data has been the strongest across developed nations with annualised Gross Domestic Product (GDP) growth for Q2 at 2.1%, and unemployment at all-time lows. Despite this, the Fed is expected to cut interest rates for the first time in a decade this week, along with two more cuts by the end of the year. The rationale is that the Fed wants to sustain economic growth in the face of headwinds from abroad, most notably the ongoing trade war with China. What's more, with US inflation below target, monetary stimulus can lift core inflation closer to the desired 2.0% level.
With US equities and Treasury prices at all-time highs, lowering interest rates may come to haunt the Fed later down the line. US inflation may not continue to be as tame as expected, and cheaper borrowing could inflate US assets beyond their intrinsic value. This increases the risk of future asset price crashes, potentially ending the sustained expansion that the Fed is targeting.
Bottom line: The Fed's in the spotlight this week, and markets have fully priced in a July rate cut. Last week, the ECB kept rates on hold and were arguably not as dovish as expected. If the Fed follows suit and keeps rates on hold, the market reaction will likely be more pronounced. However, this seems less likely given that the Fed has much more room to cut rates than most central banks.
Over the past week, the Bloomberg Dollar Index has had a nearly uninterrupted run higher and looks set to continue leading into this Wednesday's Fed rate decision. Sterling continues to depreciate as no-deal risks continue to rise; the Bloomberg Pound Index is sitting at the very bottom of the range at today's open.
Like the Pound, the Bloomberg Euro Index is sitting at the bottom of its range; in this case, that means two-year lows. Both central bank guidance and economic data releases have made it clear that EU growth is slowing. A raft of EU data out this Wednesday will likely continue this theme, but it is relatively quiet until then. The pair is likely to trade based on UK news headlines rather than fundamental data releases.
The pair is sitting at two-year lows, with the US Dollar on the front foot in today's trading. The Fed rate decision is the highlight of the week, where the Fed is expected to cut rates by 25bps. Given the growth disparity and policy setting differences, the US appears to be the preferred investment environment, which suggests the potential for further appreciation of the Dollar during the week.