Currency expert Greg Gibbs, updates on the AUD versus the USD and takes an in depth look at the GBP given Brexit
Brexit political risks are still high, but appear to be diminishing despite the odd setback. In Australia, political risks are also high as the election comes into focus.
The EUR has fallen recently and faces renewed political risk related to Italy. At the margin, this adds some downside risk for the GBP; since where the EUR goes, the GBP will follow to some extent.
AUD has fallen more than most this year against a resurgent USD
The AUD has slipped against a stronger USD this year, but how has it gone against a wider set of its peers? The answer is not too well; in fact, it sits at the bottom of the pile against a set of other developed currencies shown in Figure 1. The graph includes EUR, JPY, GBP, CAD, NZD, and a broad index of 22 emerging market currencies shown in purple.
Currency performance against the USD year to date
Source: Bloomberg
Figure 1
The USD was broadly weaker until end January, and it was mixed and ranging on average through to mid April. Since then, it has strengthened across all currencies.
So why has the USD rebounded? It is due to a combination of the following factors:
- US yields rose more than all others
- Weaker Eurozone economic reports
- More resilient US economic reports
- A major correction in global equities at end January, since followed by volatile trading
- Trump trade protectionist policy developments
We could say much about the nuances and interactions of these factors and other developments that have turned the USD around this year. It does appear that the USD may remain relatively strong for some time. However, we thought we might use this article to talk more about how the AUD stacks up against the GBP.
GBP one of the better performers
One of the better performing currencies this year has been the GBP. In fact, up until mid April (when the USD began its fight back), the GBP was top of the pops up 6%. However, it sunk quite quickly along with others, but a bit more rapidly and in the last month, gave back all of its gains this year.
Big picture GBP is cheap, AUD close to average
Before we get into recent developments, let’s compare the big picture valuations of AUD and GBP. Looking at real effective exchange rates (REERs – trade weighted indices adjusted for relative inflation), the AUD is a little above its long run average and the GBP is around 14% below its long run average. Considering the UK does not have big terms of trade swings like Australia, this is a significant and near a record degree of ‘cheapness’ relative to its history.
The latest Bank for International Settlements (BIS) measures are for April, and knowing that the AUD has fallen since then, it is now a bit lower than +2.9% above its average. The RBA measure is higher (+10.4%), but the latest data is a Q1 average, so the RBA’s measure does not pick up much of the AUD’s recent fall.
REER – rebased on the 20-year average
Source: Bloomberg
Figure 2
The Bank of England (BoE) commented in its May quarterly Inflation Report; “sterling …. remains around 15% below its peak in late 2015.” Our chart above shows that this late 2015 peak was close to its long run average; it was the peak before Brexit risk began to tighten its grip on the GBP.
The Brexit referendum on 23 June 2016 pushed the GBP sharply lower, with the low point in October 2016 after the new UK Prime Minister May told us “Brexit means Brexit” and the market began to absorb the enormous risks and difficult task ahead negotiating new trading relations with the EU.
UK rates rising
Rising interest rates have helped support the GBP since last September.
The BoE cut rates from 0.50% (in place since the 2008 financial crisis) to a record low of 0.25% in August 2016. At the same time, it restarted its asset purchase plan for a time to help alleviate the UK economy from the worst of the Brexit uncertainty. The UK economy did better than dire projections and after around a year, the bank decided it was time to lift rates.
Of concern for the BoE was the rise in UK inflation well above its 2% target and diminishing capacity in the economy.
Higher rate talk helped bolster the GBP at a time of rising UK political uncertainty late last year, and helped sustain its gains through to its high in April this year. Some cooling in rate hike expectations in the last month contributed to the GBP’s recent setback.
The RBA also cut rates in 2016 twice from 2.0% to 1.5%. Since then, there has been relatively little change in rate expectations in Australia.
UK rate hike expectations have helped lift GBP since September last year
Source: Bloomberg
Figure 3
In its May quarterly inflation report, the BoE lowered its inflation outlook somewhat, reducing the urgency to hike rates. UK inflation rose to a peak of 3.1%y/y headline and 2.7%y/y core in November last year, but it has eased to 2.5%y/y headline and 2.3%y/y core in March, approaching but still above the BoE’s 2% target. Australian CPI was steady in the first quarter near the lower of its 2 to 3% target range.
The BoE said that, “The current overshoot of inflation almost entirely reflects the pass-through of the boost to import prices from the depreciation of sterling.” They forecast inflation to fall back to target (2%) by mid-2020, largely as a result of the fading effect of the weaker GBP.
Little spare capacity in the UK economy
However, a key difference between the outlook for rates policy in Australia and the UK is that the BoE sees very little spare capacity in its labour market and broader factors of production. The RBA does not see the labour market returning to full employment throughout its two plus year forecast horizon.
The BoE continues to see domestic inflation pressures building. It said, “The Monetary Policy Committee (MPC) continues to judge that very little spare capacity remains in the economy.”
UK unemployment rate at a record low
Source: Bloomberg
Figure 4
UK wages rising
Source: Bloomberg
Figure 5
The BoE May inflation report still endorsed the market outlook for higher interest rates over its forecast horizon to 2020, pricing in around one quarter point per year to around 1.25% in 2020 (from 0.50% currently). It’s a gentle hiking projection and does not support the notion that the GBP should rise rapidly, but the record low level of unemployment and upward trend developing in wages suggest that there is a risk that rates could rise somewhat faster and support the GBP.
Key determinants of GBP
1. UK current account deficit a bugbear for GBP
One of the bugbears investors have with the GBP, contributing to its deep slide after the Brexit vote, is a persistent UK current account deficit. It reached a record wide point around the time of Brexit at over 6% of GDP. It has since narrowed to 3.6% of GDP in Q4 last year. But most of this improvement reflects a narrower income deficit.
The Goods and Services Trade Deficit is less alarming at 1.5% of GDP in Q4. It has improved in recent years but only modestly (from 2% around the time of the Brexit vote in 2016).
Australia has also had a long lived current account deficit at 3.1% of GDP in Q4-2017. But it appears set to improve significantly in Q1 this year (by around 1%) following a rebound in the trade balance in Q1. The improvement in Australia’s external balance, driven by the mining investment boom of the last decade, is a plus in the column for AUD over the GBP.
2. UK trade in services
One significant difference between the UK and Australian trading performance is that the UK appears increasingly reliant on trade in services. This is reflected in a wide and widening goods trade deficit (-7%) and a rising services surplus (+5.5%).
Australia has a surplus in goods trade near 1% of GDP and a near balance in services trade.
The strength of the UK’s services trade balance is indicative of the importance of the service sector in the UK economy, in particular financial services. One of the biggest concerns has been the impact of Brexit on the leading role London plays as a hub for global finance, and for institutions using it has a home base for operations in Europe.
By way of comparison, UK services exports are around 14% of UK GDP, rising from around 10% ten years ago. In Australia, services exports, which often discussed as a new growth area (in education and tourism), are only around 5% of GDP.
So what happens to the UK financial services sector after Brexit could be crucial for the UK economy and GBP. The latest economic data on trade in services suggests that there has been little net impact to date.
3. UK access to EU markets
A key question is what happens to financial institutions’ (FIs) so-called ‘passporting rights’ that come with the UK’s current membership to the EU ‘single market’? These allow FIs to sell services across the EU without setting up subsidiaries in the EU (and vice versa). This has been a major fear element weighing on the GBP over the last year.
However, there appears to be more confidence that a deal of some kind will be struck to maintain a high level of access for FIs between the UK and EU. In discussion is an ‘equivalence’ regime that would allow UK FIs to operate in the EU if the UK legislation and supervisory standards were judged to be equivalent to EU law.
At this stage, it is hard to say if financial institutions will move services and income generation out of the UK. In many cases, FIs may only move processing abroad, while retaining front office operations and staff in London.
The issues facing the UK financial service sector are essentially the same across the whole economy. To the extent that the UK forms part of an integrated production chain with Europe and trades in general with the EU, Brexit is generating considerable uncertainty. This has curtailed business investment in the UK although to date, there has been little net impact on trade flows.
A short history of the GBP
The height of Brexit uncertainty was late 2016 and the first half of 2017. Since then, GBP has been clawing back lost ground.
AUD and GBP vs. USD
Source: Bloomberg
Figure 6
The GBP continues to trade off the ups and downs in UK politics and news flow on Brexit dealings inside the Tory cabinet, the UK parliament, and with the EU negotiators. The news can be overhyped and hard to interpret, making for difficult trading in the GBP.
The GBP had a setback in June 2017 after PM May took the UK to a national election in hopes of securing a larger majority and a clearer authority to negotiate with the EU on Brexit. However, she failed miserably and clings to power with the support of the Democratic Unionist Party of Northern Ireland.
Since then, there has been the odd rumour that she was about to be ousted by her own party causing periods of weakness in the GBP, especially late last year. However, her resilience and a lack of credible alternative have helped calm political risk in the UK.
Towards the end of 2017, Brexit uncertainty eased significantly after protracted negotiations over a ‘Divorce bill’ were resolved, allowing talks to move onto the crucial issue of trade and a transition period after the 29 March 2019 Brexit date.
On 19 March this year, the GBP received good news that the UK and EU had agreed on a transition period that would extend the status quo until the end of 2020. In the transition period, the UK is free to start negotiating trade deals with other non EU countries, and it gives companies breathing space to plan for post Brexit arrangements. However, the UK is still supposed to meet the March 2019 deadline for agreeing on the terms of a Brexit deal.
The thorny issues of trade relations and the closely related topic of what to do with the Ireland/Northern Ireland border are now being hotly debated inside the Tory cabinet.
Time is running short to meet the March 2019 deadline, and a highly divided UK parliament has to vote on a final deal, but from afar it looks like progress is being made. The key issue for the economy and GBP is reducing uncertainty for business and retaining as much access to the EU market as possible. It does appear that the UK is making progress and Brexit risk is gradually being reduced.