Tempting as it may be now is not the time to pick bottoms in currencies and this is true for sterling, euro and even USD/JPY. The fallout from Britain’s decision to leave the European Union continues as currencies and equities endured another session of heavy losses. Since Britain’s historic decision, we’ve seen the resignation of the Prime Minister, an open revolt in the Labor Party, a downgrade by S&P and Fitch from AAA to AA, widespread confusion, major losses for sterling, steep declines in European bank stocks, talk of jobs moving to Europe and another Scottish Independence referendum. The U.K. government’s refusal to invoke Article 50 quickly complicates the outlook even further. Unfortunately the weekend brought more confusion than clarity with some optimists hoping that the U.K. will hold a second referendum on independence, which is wishful thinking. Outgoing PM Cameron said today that he and the cabinet are clear “the vote to exit must be accepted,” so the chance of another referendum is extremely slim. Today’s ECB summit would have been an opportunity for policymakers to calm the markets but Fed Chair Janet Yellen, BoE Governor Mark Carney and even ECB President Mario Draghi pulled out because they weren’t prepared to discuss their response to the U.K. referendum.
Sterling has fallen more than 11% from its Friday high and we anticipate another 4 to 5% decline over the coming days/weeks. Yet it is important to know that the next level of support for GBP/USD is 1.3040, the July and September 1985 low. Even if the leave camp is right and the long-term consequences of Brexit will be minimal (we disagree), in the near term, investors, business and consumers hate uncertainty. It is safe to say that all three will avoid major investments over the next few months in fear that the forecasters are right about Brexit triggering recession. We’re not sure the impact will be that dramatic but growth will definitely slow as investment and consumption contract, house prices will slide and the falling pound plus rising inflation will drive down wage growth. There’s no doubt that some jobs will be moving to the continent and the U.K. as a whole will provide smaller contribution to world GDP. In response the Bank of England may have to lower interest rates or revert to Quantitative Easing. Ten year U.K. Gilt yields have fallen to a record low below 1% as swap markets price in a 50% chance of a rate cut in the next month and 80% chance of easing by the end of the year. Even if they don’t follow through, there’s a very good chance that central bank officials will signal that possibility in the coming days and that could be enough to send sterling to fresh lows.
Britain’s decision to leave the European Union is also negative for the euro on a short and long-term basis. In the near term, risk aversion and market uncertainty makes the euro less attractive to investors. The European Central Bank is very dovish and had Mario Draghi not bailed out of his own summit, he would have probably reminded everyone of the central bank’s willingness to “do everything that it takes” to ensure financial and price stability. The ECB bought peripheral bonds aggressively on Friday and their buying continued into Monday. In the long run, Brexit also raises questions about the Eurozone’s viability because if major countries like Britain start dropping out the EU, nationalism could drive smaller Eurozone nations to exit out of the euro. If measured today, all Eurozone sentiment indicators will be lower than previously reported because uncertainty in the U.K. means uncertainty for the Eurozone. We are looking for EUR/USD to make another run for 1.09.
The U.S dollar traded higher against all of the major currencies today except for USD/JPY, which followed stocks lower. Although this morning’s U.S. economic reports missed expectations and 10-year Treasury yields hit fresh 3 year lows, investors are flocking into the safety of U.S. dollars. While the sharp slide in U.S. stocks tell us U.S. markets aren’t immune to Europe’s troubles, at the end of the day they make U.S. assets more attractive. Also, the Federal Reserve won’t be able to raise interest rates in this type of market environment, which is actually good for the economy and stocks. We did not hear from any Federal Reserve officials today but Treasury Secretary Lew described the markets as “orderly,” said there’s no sense of a financial crisis developing,” and indicated that the U.S. has no reason to intervene in the FX markets.” So if investors were hoping for coordinated action, they will need to wait longer. Meanwhile the U.S. trade deficit ballooned in the month of May and service sector activity slowed although economic activity as a whole improved according to Markit Economics. Revisions to first quarter GDP, house prices and consumer confidence numbers are scheduled for release on Tuesday. USD/JPY ended the day unchanged but the path of least resistance is still lower – 104 is resistance, 100 is support.
The Canadian, New Zealand and Australian dollars fell sharply against the greenback as oil prices continued to fall and gold prices advanced only slightly. There was no data from Australia but New Zealand reported a larger trade surplus. The big story in Asia however is the sharp devaluation of the Chinese Yuan. China weakened its currency by the largest amount since August following Brexit and this move has taken the yuan to its lowest level in 5 years. The PBoC needed to fix the currency at a lower rate because of the sharp appreciation of the currencies in its basket, particularly the U.S. dollar in order to maintain competitiveness. A weaker Yuan is exceptionally bearish for AUD and NZD because they rely heavily on Chinese demand. Although both currencies offer a generous yield compared to the rest of the world that may not be enough if the Chinese Yuan continues to fall.