It is a little over 6 weeks since the UK voted to leave the EU in the most significant upset of the British political landscape since the Second World War. Both the economy and the business community in the UK, and some would say the wider European continent, have been thrown into an uncomfortable holding pattern.

The medium and longer term outlook for businesses, both small and large, is difficult to assess at the moment – we will have to wait for data releases in August and September for that insight to reach us. If the impact on the UK economy is still very much up in the air, then the expected headwinds to the European economy and the subsequent effect on both the UK and European currencies’ relationship with the USD will take a while to materialize.

Why hasn’t EURUSD crashed on the basis of a Leave vote?

bloomberg graph 1

Graph used with permission of Bloomberg Finance L.P.

EURUSD has moved lower in the aftermath of the UK vote, mainly as a result of dollar strength in a climate of risk aversion but only by 2.5%. There are a number of reasons on both sides of the Atlantic why some more significant moves could be in the offing.

Political risk

2016 has been the year of political risk; the Brexit debate, the refugee crisis in Europe and the ascent of Donald Trump closer to the Presidency than anyone thought have made geopolitical predictions very difficult.

We do not expect 2017 to be as aggressive, however substantial risks remain. There are four election cycles in the next 15 months in the Eurozone (Italy, the Netherlands, France and Germany) and EU sentiment is very much in a state of flux. Issues of national identity, weak economic fundamentals, substantial wage compression and security concerns over migratory flows from Syria and Turkey are all live issues for the European project.

We expect calls for further referenda on EU membership from populist and nationalist parties within these campaigns – France’s Front National and the Dutch PVV party the most likely to make such a vote a central part of their campaigns.

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A referendum similar to that held in the UK cannot be easily countenanced in these countries for a number of reasons and chief amongst them is membership of the European single currency. Extricating oneself from that, as was effectively wargamed during the threat of a Greek exit, is an entirely different kettle of nightmares. That said, it is yet another stick for Exit voters to beat the status quo with.

Similarly, news from Turkey is extremely worrying.  The coup and counter-coup that has allowed President Erdogan to clear the house of any and all members of Turkish institutions that may disagree with him, has changed the relationship between Turkey and Europe. So far, Turkey has been helping Europe with the influx of migrants and refugees from the Syrian civil war. Any souring between Turkey and the EU could make this issue a lot more time-consuming, painful and inaccurate to police for Europe.

In the grand scheme of things it is what these issues come to represent that is the most important thing to bear in mind. Politicians of every stripe and nationality have acquitted themselves poorly through the Global Financial Crisis, and subsequently, but nowhere more so than in the Eurozone.

Whether there are issues stemming from Greece, the banking system, immigration or terrorism, it has only been at the eleventh hour that action has been taken. Proactivity is a dietary aid in European political circles.

The risk therefore is that issues that take political focus away from the economics of Europe mean a slower and more unpredictable recovery for the wider Eurozone and therefore a greater pressure on the European currency as a result.

We expect growth differentials to be key. We have lowered our growth forecasts for the Eurozone in the aftermath of the Brexit vote and should US growth accelerate to close to 3% in the second half of this year then we can see some compression of EURUSD.

Policy risk

On August 4th the Bank of England fought back with cuts in interest rates to fresh 322 year lows and a slew of new policy measures. The 6 members of the MPC who voted for all the stimulus are treating the battle against a post-Brexit slowing of the UK economy like a street-fight; hit them first, hit them hard and make sure they don’t want to get up. This move by the central bank is that first punch.

There had been some doubts that the data picture may not have given the Bank enough insight for them to begin a policy of stimulus; these were wrong and the combination of interest rate cuts, quantitative easing spending, including a corporate bond buying program, and a new funding scheme for banks make this a policy toolkit that is set to dig the UK economy out of any mire it may fall into as quickly as possible.

We would expect any increases in stimulus to weaken sterling to fresh multi-year lows, exacerbating the worsening of trade conditions in Europe. This would in turn slow growth on the continent and prompt a stimulatory impulse in the form of increased QE from the European Central Bank, possibly as soon as September.

Additional euro weakening is contingent on further QE from the European Central Bank, however the already depressed nature of European government debt means that there is little extra room for yields to fall. This will act as a barrier to substantial declines in the single currency.

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Graph used with permission of Bloomberg Finance L.P.

Rate expectations in a post-Brexit world are a difficult beast. Markets are currently only pricing in 15bps of hikes from the Federal Reserve in the next 12 months; a number that looks very cheap given the recent run of US data.

That ascribes a 37% probability of a hike in interest rates by the end of the year and while the Federal Reserve has been quick to find the grey cloud amongst the silver linings, we have to think that should the US data picture continue to look as rosy as it does at the moment, then we can look for a cheerful return to higher rates in the US sooner rather than later.

If there is going to be a rate hike this year, we think it will take place in December so as to allow the Federal Reserve some insulation.

The Elephant in the Corner

On November 8th the American people will head to the polls to vote in an election which has the world on tenterhooks. There are very many similarities between the election and the Brexit scenario, for example:

  • One option represents the status quo, the other a radically different approach
  • One option has laid out policy ideas, the other has depended on slogans and bluster
  • One option is (and has been) the overwhelming favourite, the other is definitely the outsider according to polls and betting markets
  • Immigration is the number one campaign concern
  • Both options are seemingly rather unpopular, according to polling.
  • One option is completely priced in to asset markets, the other represents an almost unpriceable risk

I do not think it is difficult to work out which one is which.

Donald Trump is a candidate from which we are unable to divine a strategy. He is an enemy of international trade as done through NAFTA, TTIP and the TPP deals and is set to take a combative stance with China on trade, currency manipulation, Asian territorial disputes and financial influence. His policy on Mexico is to build a wall between the US and its third largest trading partner.

I believe that the investment community’s foundation belief is that Trump would take the US economy into trade wars, which in turn could lead to a degree of panic or protracted uncertainty in asset markets. Intervention and/or stimulus by the Federal Reserve would likely result and in this case we are unsure as to how the dollar would react; for every time we have seen a US political event send the USD lower we have seen one which has boosted the value of the greenback.

As the below graph shows – Democrats in Blue and Republicans in Red – neither party can be seen as particularly good or bad for the US dollar.

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Graph used with permission of Bloomberg Finance L.P.

Likewise, Trump would be a Republican President with a Republican Congress behind him; he is going to have power to his elbow. His main domestic policy is to cut tax a la Ronald Reagan; moves that would be easy to get through a Republican Congress and would have a widely positive impact on asset markets.

Clinton is seen as a safer choice and although she would most likely campaign and govern from the centre ground, concessions to the further left elements of her party that will likely elect her may have to be made. Her appointment of a dependable if slightly middle-of-the-road VP candidate in Senator Tim Kaine should solidify the business community vote.

At the moment, markets are almost 100% pricing in a Hillary win and we are unsure as to how a Trump win would be priced in to asset prices although we would look for USDJPY to fall with EURUSD coming along for the ride.

EURUSD in all of this mess

First things first, these markets are a mess and predictions remain little more than a fool’s errand, but the balance of probabilities leads us to believe that we have not seen the last of EURUSD downside in 2016 and into 2017. The below chart of predictions shows an over 30% differential between high and low expectations in the coming 12 months.

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Graph used with permission of Bloomberg Finance L.P.

In conclusion, it is obvious that while the focus of near-term Brexit risks will be focused on the UK it is far too early to say that the second round effects, economically and politically, will not land further pressure EURUSD and GBPUSD lower as we try and traverse the second half of the year.