Following on from last week’s look back at 2019, this week we take the opportunity to look ahead at 2020. What can we expect from Brexit? Will the Fed continue cutting interest rates? Will we see a rise in FX volatility after a slump to some of the lowest levels on record? Here’s a look ahead at what we expect in the coming year:
Unsurprisingly, Brexit remains the key influence for sterling. The immediate focus is on the withdrawal agreement which was debated in Parliament last week and the Bill has now been sent to the House of Lords to begin its examination of the legislation. Given the Government’s substantial majority in the Commons following the General Election, it should have little trouble passing the Bill or defeating the amendments tabled by opposition parties. Any delay would almost certainly have a negative impact on the pound amid further uncertainty.
Looking forward, the bigger question is whether the Government will be able to negotiate a trade deal with the EU before the end of the transition period. Boris Johnson has stated that he will not extend the transition period beyond the end of 2020 which makes the timeline tight. Sterling fell on this news amid concerns that Britain could end up leaving without a trade deal (i.e. a hard Brexit) because a deal cannot be negotiated in time.
|Brexit Outcome||Probability||GBPUSD Target Range|
|Deal (Soft Brexit)||85%||1.30-1.35|
|No Deal (Hard Brexit)||14%||1.10-1.15|
Key Risk Factors / Dates
· 29/30th January – EU Parliament to approve withdrawal agreement. This should be a formality as Brussels have been consulted throughout the past two years of negotiations.
· 31st January – Deadline for the UK’s withdrawal from the EU. Given Boris Johnson’s overwhelming majority in Government, this should also be a formality.
· 12th March – EU trade ministers meeting in Brussels. This may give us a steer on how trade negotiations are progressing.
· 26/27th March & 18/19th June – EU summits in Brussels. Again, these are likely to be a progress update regarding trade negotiations.
· Unknown date in June – EU / UK high-level meeting to discuss political declaration on the future relationship that accompanies the withdrawal agreement.
· 30th June – Deadline for deciding whether to prolong the transition period by one year or two years. Johnson has pledged that the UK will not be looking to extend the transition period.
A second important factor to consider is the outlook for UK interest rates. Dovish comments from Mark Carney were followed up over the weekend by Gertijan Vlieghe speaking to the FT over the weekend where he said that he would vote for a rate cut if key data does not show a bounce in the economy following the December general election.
Clearly its too soon to draw any firm conclusions, but this morning’s manufacturing and industrial production figures for November were weaker than expected while the latest GDP figure (for November) showed a monthly contraction of 0.3% (the three-month average was just +0.1%).
We expect the MPC to wait for December / January’s data (to see if there was a post-election bounce) before taking any action, but the market is starting to think otherwise. At the beginning of the month, the market was pricing in a 7.5% chance of a rate cut when the MPC meet on 30th January. This morning, that probability rose to 52%!
Given that we don’t expect a rate cut from the MPC in January, and also question the likelihood of a February hike, we see plenty of upside potential for the pound in the coming months. Whilst this is likely to be kept in check by a strong dollar, we continue to believe there is scope for sterling to outperform. We are a little more cautious going into the latter stages of 2020 as there will almost certainly be some nervousness over whether a UK/EU trade deal can be negotiated before the end of the transition period, but overall, we continue to see the probability of Britain leaving without a deal as being very low (even if it means Boris has to backtrack on his pledge not to extend the transition period).
|GBPUSD||Q1 2020||Q2 2020||Q3 2020||Q4 2020|
Undoubtedly the dominant influences driving GBPEUR over the past year have come from the sterling side (Brexit/Political uncertainty, UK interest rates). Looking ahead at 2020, we see little reason to expect any change, particularly in the short term and hence the factors discussed in the previous section are also particularly relevant here.
However, we should also consider influences from the other side of the pair, namely, to do with the euro. Regular readers won’t be surprised to hear that we remain cautious about the outlook for the single currency given weak fundamentals, the ECB’s ultra-accommodative stance on monetary policy and political uncertainty.
With the economy growing between 1.2% and 1.4% throughout 2019 and inflation consistently below the ECB’s 2% target rate, we see little prospect of tighter monetary policy in the foreseeable future. That said, the market is pricing in very little chance of any change in rates throughout 2020 so the focus will be on the likelihood of any change to the Central Bank’s asset purchase program.
As a result of our bullish forecast for sterling (vs. the dollar) and our bearish stance on the euro, we are extremely bullish on GBPEUR (certainly relative to the consensus forecast). The main risk we see to our outlook is regarding the UK/EU trade deal. If it starts to look like Boris Johnson may struggle to get a deal in place, but remain adamant that he will not ask for an extension to the transition period, the market will begin to price in an increased probability of a hard Brexit (which in turn will have a negative impact on sterling).
|GBPEUR||Q1 2020||Q2 2020||Q3 2020||Q4 2020|
Throughout the first half of 2019, we were relatively bullish on the dollar (certainly bearish on the euro) and called for a move below $1.10 despite the consensus being overwhelmingly bullish. As it transpired, the call was a good one and EURUSD fell to a low of $1.09 at the end of September before recovering some of its lost ground in the fourth quarter. Nevertheless, the most notable point about 2019 was the lack of volatility (the 2019 trading range – around 6% – was the lowest ever and compared to a lifetime average of 18%).
Looking ahead at 2020, we find it hard to envisage another year where volatility remains as compressed. So, assuming we see a trading range of >10%, the question is which direction will it trend?
Using a simple PPP model, the dollar is ~10% overvalued against the euro. Meanwhile, the US economy is still at risk of slipping into recession (meaning there is scope for more monetary stimulus from the Fed) and we shouldn’t ignore the twin deficits (although the market has been happy to in recent years). There is also the small matter of a presidential election towards the back end of the year. Based on this, there looks to be plenty of scope for the dollar to come under pressure and finally endure the meaningful depreciation that the market has been looking for over the past two years.
However, there are a couple of points that are preventing us adopting a bearish view on the dollar at this stage. Firstly, as highlighted earlier in this report, we remain bearish on the euro. Secondly, even if the US economy does enter a recession, we continue to see the risk of an economic slowdown on a global scale and during such times, the dollar has a history of benefiting from its status as the world’s reserve currency. Thirdly, if expectations for progressive trade negotiations between Trump and China fail to materialise, we see scope for the dollar benefiting further.
Our high conviction call for 2020, is that we will see a significant increase in volatility. However, we have less conviction regarding the direction. Not wanting to ‘sit on the fence’ we have decided to remain bullish on the dollar / bearish on the euro for the simple reason that the dollar looks to be the least dirty shirt. Given that the euro is only ~10% undervalued, we see scope for a further 10% depreciation. As discussed above, there are clearly a number of influences which could put downward pressure on the dollar and we shouldn’t forget about the Presidential election towards the end of the year. At present, Trump looks set to remain in the White House, but if Bernie Sanders and the Democrats continue to gather support, it would likely be negative for the dollar.
|EURUSD||Q1 2020||Q2 2020||Q3 2020||Q4 2019|
Will the new year be a repeat of the historically tight USDCAD ranges, or will the mounting risks facing Canada, the US and the global economy see volatility return to more ‘normal’ levels. This will depend on what happens to the three key drivers of USDCAD:
1. The US – Canada yield differential moved heavily in favour of CAD over the past twelve months. However, given that both the Bank of Canada and the Fed are focussed on the data but have expressed concerns over domestic and global growth, putting them firmly in a dovish stance. Our house view is that the yield differential between Canada and the US will remain somewhat stable and therefore will not be a big factor in USDCAD pricing over the coming year.
2. Oil prices rallied in 2019 due to conflicts in the Middle East. While there is potentially more upside due to supply constraints in the short run, in the medium term with global growth likely to be relatively benign, CAD will suffer towards the latter half of the year.
3. The USD sold off into the end of 2019 only to rally as US tensions with Iran caused safe-haven flows to boost the big dollar. As those issues, along with the China – US trade tensions begin to subside, there will likely be an initial move lower in the USD. As we see signs of global growth and US domestic growth slowing down, that will also hurt Canada given that the US is their major trading partner.
Put these together and it points to a dip in USDCAD in the short run followed by a slow grind higher into year-end.
|USDCAD||Q1 2019||Q2 2019||Q3 2019||Q4 2019|
Author: Marc Cogliatti