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What have we been up to


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Hard Brexit fears rattle sterling

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Last week ought to have started well for sterling. Manufacturing and construction PMIs for September, released at the beginning of the week and coming in at 55.4 and 52.3 respectively, were both substantially stronger than expected – and much stronger than last month’s 53.3 and 49.2. Services PMI, at 52.6, was a tad weaker than last month, but ahead of expectations.
However, this reasonable data was overshadowed by faintly anti-business and pro-hard Brexit sentiment coming from Theresa May’s speech on Wednesday and sterling felt heavy. Furthermore, the industrial production and manufacturing output figures on Friday were weak, but this was an irrelevance given Francois Hollande’s speech at a dinner on Thursday night during which he suggested that Britain was headed for a hard Brexit and would have to pay a price for leaving the EU. This appears to have triggered some selling in the Far Eastern markets which spiralled out of control. Thomson Reuters put the low on GBP/USD that night at 1.1491, while Bloomberg recorded 1.1841. There were, however, reports of a trading platform recording a figure as low as 1.1378! Indeed, the sterling market was in such focus that the US non-farm payroll numbers, which should have been the main event of the day, were almost forgotten. (They came in at 156k in September, slightly below August’s revised 167k and against expectations of 172k – so no US rate hike until December at the earliest).
This sort of violent price action underlines why FX hedging involving barrier or binary options (i.e. options where a one-off event results in an action – either obligating the corporate to enter into a trade at an off-market rate or cancelling out protection that the corporate thought was in place) – is a very bad idea. Neither banks nor corporates have control of FX markets and sterling’s ‘flash crash’ last Friday morning, albeit short-lived, will have resulted in some customers with ‘Forward Extras’, ‘Bonus Forwards’, ‘TARNS’ or, indeed, any number of fancily-named FX structured products being triggered, resulting in the corporate either having no protection or being locked into an off-market exchange rate. Hedging with barrier/binary options is not hedging. It is speculation. The first publicised victim of the flash crash has been Sports Direct which, according to Saturday’s Telegraph, had entered into an agreement to protect it against adverse currency moves (presumably a stronger USD) which ‘unwound when the pound hit $1.1900’ costing the company £15m. There will doubtless be further such examples.
Sterling recovered almost immediately but still looks sickly. Perhaps this is all part of the new government’s plan for change. A hard Brexit triggers further sterling weakness, which generates the inflationary forces to render further cuts in interest rates unnecessary – or, indeed, leads to rate rises. This would benefit savers, which was one of Theresa May’s themes. Certainly, the gilt market reacted, with the 10 year yield up 10 basis points on the day and 25 on the week. If the government is to borrow more to spend on infrastructure, it had better get on with it while the going is good.
It is tempting to ignore President Hollande’s comments as mere pique; or to suggest that he was playing somewhat to his select audience of 150 which included Jean-Claude Juncker, to whom it seems regular pieces of metaphorical raw meat must be thrown, lest he self-combust in outrage over the sheer cheek of Brexit. However, Hollande’s comments are entirely consistent with European realpolitik. The EU has failed to reach agreement with the US on trade under the TTIP negotiations, which were formally begun three years ago and are forecast to require another three or four. It therefore appears most unlikely that much will be achieved between the UK and the EU in the two years of negotiation following the triggering of Article 50, now scheduled for the first quarter of next year. This is particularly the case given that four Eastern European member states have vowed to veto any agreement that involves restriction on free movement of people.
The prospect of another two years of acrimony is particularly unappealing, not least on account of the impact of protracted uncertainty on financial markets. Indeed, Philip Hammond suggested last week that Friday morning’s price action is the sort of thing that he expects for the next five years. If this is the case, it may well be better simply to cut loose, opting for hard Brexit with unilateral tariff-free trade on imports into the UK. Most tariffs on imports into the EU are only 3.5%, which is hardly a disaster. It is true that the tariff on cars is 10% and this would be hard on Honda, Nissan and Toyota, who all produce in the UK for the EU market. However, they have already gained more than that via sterling’s depreciation since the referendum  and car exports from Japan to the UK will be free from the 10% EUR tariff in under two and a half years’ time. As for the City and ‘passporting’, there will be many who argue that Britain’s over-reliance on financial services needs addressing and that Moody’s assessment last month of the prospect of losing passporting rights for most banks and financial institutions suggests that such an outcome would be manageable. Hard Brexit is the quickest way to bring certainty to the markets and define a base for sterling, but that will not stop the pound being sold off further in the short term as this uncomfortable truth becomes recognised.  
If it is true that there are certain moments in history that mark a turning point, then last week’s news that Italy managed to issue €18.5 billion of 50-year debt at a mere 2.8% must be a contender – particularly ahead of the referendum on 4 December that has the potential to bring down Matteo Renzi. In order to rationally lend to the Italian state at 2.8% for 50 years, one would have to be more certain about a range of issues (lack of inflation, economic and political stability, a satisfactory solution to the North African migrant crisis, improvement in the birth rate etc) than it is surely possible for anyone to be. However, these are not normal times. While we may well look back on last week as confirmation of August’s low point in Italian bond yields, we may yet be surprised again by further declines – particularly given Italy cannot follow Britain’s lead on currency depreciation.
There is little UK data this week that is likely to move the markets (not that it is the data that is causing the volatility at the moment). The MPC meets on Thursday but no change is expected to either base rate or the QE programme. In the US, we shall see a raft of data on Friday, including retail sales for September (expected up 0.5% m/m); PPI (expected up 1.2% y/y ex food and energy) and the preliminary University of Michigan Sentiment Index (expected at 93.0 in October – up from September’s 91.2). In the eurozone, Wednesday sees industrial production for August (expected +1.5% y/y).

All views expressed here are the author’s own and are based on data and information available at the time of writing.



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