Brexit might reverse the great divergence trade
The last couple of weeks have been pivotal for the divergence forces at work in the forex markets with the UK being the latest country to pull in the opposite direction of the US on monetary policy as the Federal Reserve inches towards an interest rate rise.
However, a rampant USD -- egged on by strong jobs numbers, followed by one interest rate rise this year -- may not happen. True, the USD index has risen since May from around 92.60 to 96.19 on Friday and is close to its peak at just over 100.30 seen in March 2013. It may well challenge that level and even surpass it for a short while, but if the nascent post Brexit changes really do play out – then USD’s advances are likely to be capped as the divergence story starts to unwind.
And in one crucial respect the Brexit vote may have been a game changer for the global economy. It’s presented an excuse for some countries to ditch austerity packages in Europe (UK is doing so and anti-austerity calls are gaining strength in the Eurozone), and for others to embark on new fiscal stimuluses, such as Japan (public / private stimulus worth up to $250bn).
With interest rates at near zero or even in negative territory and following years of quantitative easing programmes – central banks are near to reaching the end of what they can do for the real economy. QE has fostered inflation in asset prices whilst keeping the money supply stable. If the money supply had been allowed to contract – economies would have imploded like they did during the Great Depression of the 1930s.
In effect, central banks are trying to pass the baton to governments with Japan taking the lead. Spending by governments should do more to stimulate the real economy and prices. In theory this should take the pressure off central banks to keep pushing towards ever more extreme monetary stimulus measures. Interestingly, JPY has been strengthening again since late July and is coming close to challenging the psychologically important USD/JPY 100 level.
Meanwhile, the Bank of Japan is in a quandary over its 2% inflation target, which it has never consistently met. In the run up to September we should get more clues as to whether the BoJ intends to throw in the towel on depressing JPY and firing up inflation, and let the government’s fiscal stimulus lift prices, or if it is still very much in the fight.
The UK meanwhile has cut interest rates and restarted quantitative easing with the government also abandoning its budget targets. If the economy recovers quickly – after all the UK is still in the EU and the very negative sentiment readings may have been overdone – then the Bank of England’s most recent stimulus could be reversed quite soon. Indeed, support above GBP/USD 1.3000 appears to be robust.
So in essence a move towards global stimulus packages from China to the UK and with the growing prospect of some Eurozone countries joining in (plus a strong US economy) could rekindle economic growth for up to a few years. This should favour risk currencies (some are already on the up as are risk assets such as equities) and take some pressure off central banks and see those currencies gain against USD as inflation expectations rise along with real interest rates i.e. credit to households and businesses.
TECHNICAL ANALYSIS: EURUSD – more falls likely in the short-term
EUR/USD appears to moving closer to potentially challenging key support levels at around 1.0970, 1.0950 and even 1.0777, helped by strong US jobs numbers and the crisis situation with Italy’s banks, which remains unresolved. Getting below 1.0970 will take some strong catalysts as support around those levels has been strong.
This Friday, sees US core retail sales, producer price inflation and preliminary UoM consumer sentiment, which can all be big market movers. Beyond that it’s a case of keeping an eye on the news flow and the evolving Italian banking crisis, which as usual, has been greatly complicated by Eurozone politics.
In the meantime, EUR/USD briefly punched through the upper Bollinger band early last week and has pulled back with the likelihood that it will head to the lower band as it has done on many previous occasions. Also, the daily slow stochastics issued a strong sell signal last week, which appears to be still playing out.
Any up-move is likely to encounter resistance around 1.1149, 1.1197 and 1.1222
By Justin Pugsley, Markets Analyst, MahiFX