FOREX Analysis. Pound soars on fiscal spending hopes – but is it a dead cat bounce?

Dollar1Euro/dollar drifts lower as European exodus accelerates

Another day, another multi-year low for euro/dollar, which continues its astonishing collapse having fallen in eight of the last nine sessions. The virus outbreak eradicated any surviving hopes for a real economic recovery in the euro area, as China is Germany’s largest trading partner, so the inevitable slowdown in Chinese demand will severely impact European firms, not to mention supply chain disruptions.

In contrast, the American economy is still firing on most cylinders, and is probably better equipped to weather a shock in China as Trump’s tariffs already initiated a rotation of US supply chains away from China. Interest rate differentials between the two economies are still wide and although markets are pricing in one and a half Fed rate cuts by December, they are also anticipating more ECB stimulus, so the dollar-positive carry trade is unlikely to disappear.

Sluggish European growth has the market pricing in a ~60% chance of another 10 basis points rate cut by the ECB this year, something ECB Vice President de Guindos teased recently, by saying the central bank hasn’t reached the ‘reversal rate’ yet. This is the rate after which further cuts do more damage than benefit to the economy.

Admittedly, since European fiscal stimulus is not on the horizon, there are two ways this can play out. Either the ECB will indeed add more stimulus before long – slash rates, increase its QE dose, or both – or policymakers will be so divided that no stimulus will come, which would probably be seen as a policy mistake by the market. Both scenarios are euro negative.

Pound soars on fiscal spending hopes – but is it a dead cat bounce?

The British pound came back in the spotlight on Thursday, outperforming all its major peers after – ironically – the Chancellor of the Exchequer Sajid Javid resigned. He will be replaced with Rishi Sunak, who is a fast rising junior that PM Johnson will probably have a lot more control over.

Markets took this as a sign that the budget the government is set to unveil next month will include greater spending to bolster the struggling UK economy. By extension, that would imply a smaller chance for the Bank of England to cut rates soon, which propelled the pound higher.

However, several risks remain. For one, assuming this resignation will lead to serious fiscal easing may be wishful thinking. The Tories were reluctant to promise a serious spending boost ahead of the election – why turbocharge it now they’ve won? Beyond economics, the Brexit negotiations restart in two weeks, and whoever thinks they will be plain sailing or that the threat of a no-deal exit won’t return is probably in for a rude awakening. Hence, this seems more like a dead cat bounce for Cable, not the beginning of a healthy uptrend.

Can’t keep US stocks down, but anxiety lingers

The unstoppable freight train in US equity markets just keeps on rolling, with the S&P 500 (-0.16%) recovering a large part of its virus-related losses yesterday to close within breathing distance of its all-time highs once more. Setbacks in stocks have consistently provided investors with renewed buying opportunities lately because in an environment flush with central bank liquidity, investors are willing to take more and more risk, making ‘all news good news’.

Yet, other segments of the market tell a different story. The defensive yen held onto most of its gains yesterday, while gold prices climbed even in the face of a stronger dollar, so traders are conscious of the various risks and are simultaneously ‘playing defense’ by hedging their stock exposure.

As for today, retail sales data out of the US could be crucial in deciding whether the Fed will put its finger on the rate-cut button soon, and therefore for the dollar’s direction.

Origin: XM

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