2016 will forever be remembered for the impact political unrest has had on the currency markets. Businesses involved in Foreign Exchange have all been impacted by the UK’s decision to leave the EU. A controversial celebrity being elected as the US President and a new unelected Prime Minister at number 10, all contributing to extreme market conditions and major currency fluctuations.
Media across the globe has heavily documented the foreign exchange volatility and the impact it has had on importers as well as to exporters and inevitably increased costs to consumers. This article is aimed to help give 2016 some context and help our clients prepare for the next six months to try to mitigate the volatility caused by exchange rate fluctuations.
On the 23rd June the UK voted to withdraw from the European Union with 51.9% of votes in favour of leaving the European Union. This was a surprise to most, with the majority of polls predicting a remain vote.
As news broke the Pound had its biggest ever one day drop since free floating exchange rates were introduced in the 1970’s. This was the single largest one day fall of any of the world’s four major currencies. The political uncertainty was far from over in the Brexit aftermath with the incumbent Prime Minister David Cameron resigning hours after results were announced. Further political uncertainty, a credit down grade and poor sentiment heaped more pain on importers and consumers. Panicked investors forced the Pound a further 10% lower from the period July to October 2016.
After several weeks of Tory Party in fighting the leadership crises had abated with Foreign Secretary Theresa May named as the UK’s new Prime Minster. Described as a “Pragmatic reformer” Mrs May was handed the unenviable task of guiding the UK through its divorce with Europe.
Expansionary Monetary Policy
The Bank of England (BoE) offered a swift response to news of Brexit, offering a helping hand to businesses and consumers by slashing interest rates from 0.5% to 0.25%. The BoE also relaxed Bank reserve capital requirements, freeing up capital and allowing banks to lend more to businesses and individuals. The goal of the BoE with these actions is to stimulate the British economy when Brexit begins to bite, providing households with more purchasing power and businesses with greater access to credit.
The whirlwind economic and political issues of June were Trumped in October, when a controversial Republican candidate was elected as the new US President – to the surprise of many. Donald Trump managed to take control of major swing states including North Carolina, Ohio and Pennsylvania. In an extraordinary twist, the new President elect also secured the ‘rust belt states’ as well as some traditionally Democrat battlegrounds. Many thought he would never achieve this but the Republican candidate had reached the key 270 mark of electoral votes.
The initial impact of Donald Trump as president on global markets was negative as both commodity and equity markets weakened with USD on the back foot and safe haven currencies being heavily bought. However, once it was officially announced that Mr Trump had been elected as the new US President; markets reversed rapidly with the Dollar making back it’s losses. The following days proved to be reassuring for Sterling, with many viewing Mr Trump’s election as a positive for the pound with Trump giving indications that the UK would be at the front of the queue when it came to trade deals. Most analysts agree Trump’s policies to cut tax, increase infrastructure spending and try to curb cheap imports from China will lead to higher inflation in the US during his term as President.
LOOKING FORWARD TO MORE SETTLED WATERS?
The British government is appealing against a legal ruling stating that it needs parliamentary approval to trigger the formal Brexit process. London’s High Court ruled in November that the government does not have the constitutional right to start the process without the backing of lawmakers.
Prime Minister Theresa May has insisted that she will invoke Article 50 of the EU’s Lisbon Treaty before the end of March 2017, thus beginning two years of formal exit talks, expected to conclude with Britain leaving the EU in spring 2019. Europe’s leaders, such as Angela Merkel and Council President Donald Tusk are united in their determination to delay negotiations on discussions until the UK formally triggers Article 50. They are adamant that there will be no side deals or talks until Britain makes their official move.
British households are likely to experience a cut in their disposable incomes in 2017, as the effects of the vote pushes inflation higher and weakens the outlook for the economy.
The government’s freeze on tax credit payments will also play a part in pushing down real disposable incomes, according to forecasts by the National Institute of Economic and Social Research.
A report from the Organisation for Economic Cooperation and Development (OECD) predicts that inflation will pick up to 2.4% in 2017 and almost 3% in 2018. The report mentioned that an inflation-induced dip in consumer spending, together with lower investment are likely to drive the UK slowdown and that these threats could prove to be worse than expected. It sees uncertainty weighing on growth and investment, higher inflation weakening consumer spending and unemployment rising.
UK – What action will the Bank of England take next year?
Following on from Article 50, uncertainty is the question driving what action the Bank of England will take. Another interest rate cut to try to stimulate the economy is not necessarily the most likely outcome. Carney has stated that; “You can envisage scenarios where it (interest rates) goes either way. We don’t have a bias in terms of direction of where the next move will be. Again, in a period of a fair bit of uncertainty you can envisage scenarios where either direction would be merited”.
This statement indicates that the BoE is prepared to hike rates if the outlook for inflation gets to a point they are uncomfortable with. Given the exceptional circumstances of Brexit the BOE are prepared to let inflation run above its target of 2%. However, the BOE currently won’t be lured into giving any forward guidance on what inflation levels need to be before interest rates are increased. The ambiguity of Carney’s comments could further exacerbate sterling volatility next year. Major changes to inflation linked variables such as the price of oil, supplier prices and import costs should help shape some of the MPC’s decisions on interest rates next year.
Europe - another political sea change?
In 2017 we could see the Eurozone return to the spotlight as a number of countries in the trade bloc have their general elections. Populist support around the globe is growing as we have seen already in 2016 with a Brexit vote and Donald Trump voted in as the 45th US President. Across the English Channel we are seeing right-wing populist parties gaining popularity as Europe faces a spate of elections that are set to shape the continent’s political landscape.
In early December, voters in Italy were asked whether they would approve a constitutional law amending the Italian Constitution. 59.1% of Italians voted against the reforms, and the Italian Prime Minister resigned, leaving the country set for further instability. Around this time, Austria rejected an anti-immigration far-right leader in favour of a left-leaning candidate.
Probably the most notable and unnerving election for EU purists is the French Presidential election. National Front far-right leader Marine Le Pen, who has dubbed herself ‘Madam Frexit’, is projected to be one of the top two candidates in the first round of the election. Le Pen is currently projected to lose in the second-round to Francois Fillon, who is seen as the centre-right candidate, and favourite to become the next French President. However political analysts are refusing to rule out a La Pen upset.
The French, Austrian and Dutch governments have to answer to many disenfranchised voters, the working classes feeling abandoned, record unemployment, rapid deindustrialisation, devastating jihadist terror attacks, and a massive migrant crisis across the continent. 2017 has the potential to see a number of far right political parties come into power with a strong protectionist, anti-immigration, and an anti-EU mandate. If one or more of these parties come into power, and push for a UK type Brexit, then we could see the euro come under significant pressure as we move into 2017.
What to look out for in 2017
With an increasingly fast-changing political landscape, 2017 looks set to bring further economic surprises. RationalFX can assist you in navigating these times, hedging your risk through innovative, tailor made strategies for your business. Speak to one of our dealing team to see how we can help you navigate through an uncertain 2017.
The outlook for the Pound is shrouded in uncertainty as we move into 2017. A timeline has yet to be set for Brexit, as well as an expected date for Article 50 to be triggered by Theresa May. Currency markets are currently extremely sensitive to any news regarding the outlook for the UK regarding Brexit. So far we have seen the Pound rally on news of a ‘soft’ Brexit, and conversely the Pound has been sold off when news breaks that the UK could be in for a ‘hard’ Brexit. Until there is a clearer roadmap on how the UK will fare in its relationship with the European single market, we expect choppy trading conditions for the Pound to continue in the medium term. Our view is that ultimately the UK will be able to negotiate favourable access to the European single market. Theresa May has also held preliminary discussions with President Elect Donald Trump and Chinese trade officials. A timeline for negotiations is unclear at this point; however if trade negotiations are positive with Europe and other major trading nations, we expect the Pound to rebound off current lows. With many analysts believing that the Pound is currently oversold and trading well below fair value, we feel that risks to the downside could be limited. Ultimately, the risk still remains that a ‘Hard’ Brexit is still a possible outcome, and if this is the case, there is still scope for a continued weakening Pound.
The key theme for the US dollar in 2017 is how the US Fed will act on President elect Donald Trump’s new economic policies after the rate hike on the 14th December. With Trump being elected on a platform of infrastructure spending, tax cuts, cuts to government regulations, and renegotiating or halting of international trade agreements there is a strong argument that these policies will be inflationary, leading to further interest rate hikes and a stronger US Dollar in 2017.
All eyes will be on the political landscape of the European Union and the potential impact of the populist vote and right wing leaders. Importantly we have seen Austria reject a far right leadership however we still have key French and German elections to come. Recently we have seen the rise of the German Alternatif for Deutschland Party as Merkel’s popularity suffers. Also, high on the ECB’s agenda for 2017 is bound to be quantitative easing programmes and any potential developments from this.
To discuss any of the topics within this document please contact RationalFX and a dedicated dealer will work with you to manage your FX exposure in 2017.