RBA Meeting Preview

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The Reserve Bank of Australia meets tonight and new central bank governor is at the helm.  Phillip Lowe, former RBA deputy governor succeeded Glenn Stevens and investors will be paying close attention to the new governor’s tone. Chances are he is going to play it safe and maintain the central bank’s upbeat outlook.  The last time they convened they expressed confidence in the trend of growth and labor market.  When Lowe spoke last month, he said the labor market is not as strong as the unemployment rate suggests and inflation is expected to remain low for some time. Taking a look at the table below, there has been as much improvement as deterioration in Australia’s economy since the last monetary policy meeting with broad improvements in China.  So while RBA Governor Lowe may be optimistic, the main takeaway will be patience.  AUD may fall on this but at a time when the central banks of the U.K., Eurozone, Japan and New Zealand are considering more stimulus, a neutral bias will make any declines shallow. In fact we believe the better trade is to be long AUD pre-RBA.

 

 

Here’s How to Trade the Sept ECB Rate Decision

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The European Central Bank’s monetary policy announcement is the most important event risk on the calendar this week. Aside from the rate decision, the central bank also releases its latest economic projections which helps to shape future policy plans.  ECB President Draghi is expected to remind investors that inflation is low, the economy is weak and easier monetary policy may be needed. Consumer spending has been particularly soft, manufacturing and trade activity took a hit after Brexit and most importantly, inflation remains well below target with year over year core CPI growth slipping to 0.8% from 0.9% in August. However there have also been areas of improvement namely in business confidence, German spending and German stocks.  Some are hoping for more QE but at most we expect the ECB to extend its asset purchase program beyond March 2017.

As usual the EUR/USD there will be different phases to the currency pair’s post ECB reaction.  First, if there is no new QE, EUR/USD will jump. Then the second and more sustained reaction of the day will depend on the ECB’s guidance and their staff forecasts -- most likely these will be dovish which means weakness for the euro. However if there is no QE and Draghi stresses that they are in wait and see mode, the gains in EUR/USD will be sustained and of course if there is new QE, EUR/USD will drop to 1.11.

 

Will Aug NFPs Help or Hurt USD/JPY?

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The focus now shifts to the U.S. dollar.  Non-farm payrolls are scheduled for release tomorrow and ahead of this key event there was very little consistency in the performance of the dollar.  The greenback traded lower against JPY, AUD, NZD and CAD but moved higher versus EUR, GBP and CHF.  After the strong increase in June, there’s no doubt that job growth slowed in July and the big question is by how much. Economists are currently calling for job growth around 180K and any reading greater than 200K will be positive for the dollar as long as the unemployment rate improves and average hourly earnings rise as expected.  Any miss in the headline or underlying components will send the dollar tumbling lower.

While the leading indicators for non-farm payrolls point to a decline, the number may not be that bad.  The 4 week moving average of jobless claims declined, continuing claims are lower, Challenger Grey and Christmas reported a sharp drop in job cuts and corporate payrolls increased slightly according to ADP.  Although the employment component of non-manufacturing and manufacturing ISM declined, the dip was small and consistent with the drop in payrolls already forecasted. Consumer confidence is also down marginally according to the Conference Board’s survey, leaving the only major deterioration reported by the University of Michigan.  There’s no doubt that the U.S. economy is outperforming its peers, which should make U.S. assets and the U.S. dollar more attractive in comparison.  For these reasons and the fact that Japan’s big event risks are over, we anticipate a stronger recovery in USD/JPY.

 

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BoE Preview – Rate Cut AND QE?

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Tomorrow’s Bank of England meeting is one of the most important events this month.  Back in July, U.K. policymakers made their plans to ease in August abundantly clear and now that the time has come, sterling has been surprisingly stable.  By giving investors sufficient warning, the market had the opportunity to completely discount a 25bp rate cut and the question now is if the BoE will do more. They could cut interest rates by 50bp or they could combine a quarter point cut with renewed bond buying. Quantitative Easing was a critical part of the BoE’s monetary policy during the financial crisis but with interest rates already so low, the effectiveness of QE is in question. Many economists believe they will revive the program but not this week. Since Britain decided to leave the European Union, the Bank of England has taken major steps to stabilize the financial markets and encourage lending – and so far it has worked!  Stocks are stable, yields have increased and the doomsday sentiment in the market is fading. A lot of this has to do with the U.K. government’s decision to postpone invoking Article 50 for the next year or two, reducing the immediate risk for businesses.   This means the central bank can wait to ease again when there is a greater evidence of a deep contraction in the economy.

Taking a look at the table above, there’s certainly been more deterioration than improvement in the U.K. economy since the July monetary policy meeting. However wages are up, the unemployment rate is down and consumer prices are ticking higher.  Second quarter GDP growth was also better than expected.  Although manufacturing, services and the composite PMI indices fell sharply in July, this morning’s numbers were not revised lower after the flash release.  When the Bank of England releases their Quarterly Inflation Report tomorrow, their forecasts will be grim – policymakers previously warned of a possible recession post Brexit.  Governor Mark Carney won’t have anything positive to say outside of acknowledging financial market stabilization.  Yet economic and financial conditions are not desperate enough for the Bank of England to rekindle their QE program.

In other words, we feel that the Bank of England doesn’t need to send a strong message to the market right now outside of a 25bp rate cut and a stern warning of more easing in the coming months.  If we are right, we could see a bigger short squeeze in GBP/USD that will allow investors to reset their short positions at higher levels.  The U.K. is not out of the woods, as growth will only slow further in the coming months / years because the U.K. government is simply delaying the inevitable.  If they cut by 50bp or restart their bond buying program, sterling will fall quickly and aggressively.

RBA Rate Cut – Not a Done Deal

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The Reserve Bank of Australia also has a monetary policy announcement and the majority of economists surveyed expect the RBA to cut interest rates by 25bp but we feel that a rate cut is not a done deal.  The last time we heard from the RBA they sounded open to the idea of easing if data supports it but since the last meeting in July, manufacturing activity accelerated, consumer prices increased, full time job growth rebounded, business confidence improved and the participation rate is up as shown in the table below. Granted consumer confidence is down and the unemployment rate ticked up, we’re not sure if this is enough for the RBA to pull the trigger on easing in August. The AiG Performance of Manufacturing Index rose to 56.4 vs. 51.8 previous.  Chinese PMI numbers were mixed. The official manufacturing PMI showed a decline from 50 to 49.9. The Caixin Manufacturing PMI reading registered an increase in activity, coming in at 50.6 vs. 48.9 expected. Australia’s trade balance and building approvals report will be released pre-RBA but the rate decision will be key. If the RBA cuts, AUD/USD will drop below 0.75 cents quickly but if they hold rates steady, we should see Monday’s high of 0.7615 recaptured.

AUD

July FOMC – Reason for Fed Optimism

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Taking a look at the day to day change in the U.S. dollar, it may seem that there was very little consistency in the performance of the greenback ahead of Wednesday’s monetary policy announcement. However if we isolate the price action to the U.S. session, the dollar moved higher against most of the major currencies. This morning’s U.S. economic reports were mostly better than expected with consumer confidence beating expectations and new home sales rising sharply. Service sector activity slowed according to Markit Economics and house prices dropped slightly but that was not enough to deter investors from buying dollars pre-FOMC. During a time when central banks around the world are actively talking about and planning for easing, the Federal Reserve’s hawkish bias will shine a bright light on the dollar. Many feared that the Fed would give up on the idea of tightening after Brexit but as we have seen U.S. markets and the U.S. economy have proven to be fairly resilient.

The following table shows more improvements than deterioration in the U.S. economy since the June Fed meeting. Retail sales increased, non-farm payrolls rebounded strongly with job growth rising 287k in June, the housing market is chugging along, manufacturing and service sector activity are on the rise. U.S. stocks also hit record highs while plunging U.S. yields provide support to the economy. The currency has strengthened across the board but the strongest gains were against the British pound. We’ve also heard from a number of FOMC voters since Brexit and they still seemed to support the idea of tightening. The FOMC statement generally reflects the views of the Fed leadership (Yellen, Fischer and Dudley) and it is likely to recognize the improvements in the economy since June. Of course, there will still be notes of caution and everything will be “data dependent” but we expect the main takeaway to be that a 2016 rate hike remains on the table. The Fed needs to move forward with policy normalization and they can’t wait around for the U.K. to invoke Article 50 which could take up to 2 years. So we expect the dollar to trade higher into and after FOMC. There won’t be fireworks but there could still be some quick trading opportunities.

FOMC_July2016

Forex June Seasonality – Negative Dollar Bias

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May was a very strong month for the U.S. dollar and that was no surprise to our readers because we shared this chart at the beginning of the month showing how well the dollar performs in May.  With last month’s gains, the positive seasonal bias continued for 7 straight years but on this first day of June, we are more interested in how seasonality affects currencies in the new month.

Which is why we updated our seasonality tables --

As you can see, there’s a negative bias for the Dollar Index in June.  After strong performance in May, profit taking tends to drive the greenback lower in June.  The seasonal trends are strongest for GBP/USD, EUR/USD and AUD/USD.  However the gains in general are relatively modest with the dollar giving back only part of the past month’s moves.

Seasonal trends are important but with the Federal Reserve poised to make a major decision in June and the U.K. holding a referendum on E.U. membership -- this year’s unique factors could easily overshadow seasonal trends. With that in mind, if the U.K. votes to remain in the European Union (and we think they will), the corresponding relief rally could drive the dollar lower against sterling and other high beta currencies.

June_Seasonality

Top Forex Themes for 2016

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Top Forex Themes for 2016 Since the next two weeks are generally the quietest periods in the financial markets, we want to take this opportunity to think longer term and share with you our currency forecasts for 2016. We’ll start with an initial review of the top themes and explore them in further detail as the week progresses in our outlook for each of the major currencies. But first -- 2015 has been a big year for the foreign exchange market. Divergences in monetary policies led to strong moves in currencies with the U.S. dollar as the best performer. The U.S. saw its first rate hike in nearly a decade while other major central banks in the Eurozone, China, Canada, Australia, New Zealand and Japan eased. In response, the greenback climbed to multiyear highs and this strength translated into significant weakness for many major currencies along with a collapse for commodities. These are some of the milestones reached in currencies this year:

 

The greatest risk for the financial markets and the global economy in the coming year is the feedback loop from the dollar and Fed policy. While the quarter point hike in December represents only a nominal increase in U.S. rates, the Federal Reserve expects to tighten 4 additional times next year which will have broad ramifications for currencies, equities and commodities. In mid-December, we published a piece outlining the Consequences of a Strong Dollar and a lot of these issues will return to focus in 2016.

The first few months of the year should be good for the dollar as long as Fed officials don’t backtrack on their hawkish views. There will be more hawks voting on the FOMC in 2016 than 2015 so the balance swings in favor of continued tightening. Between the warm El Nino weather and gas prices below $2.00 a gallon in some states, consumer spending should also rise in the first quarter. So while the dollar is rich, the path of least resistance is still in higher. However our outlook changes in the second half of 2016 as we believe rate hikes and the strong dollar will force the Fed to slow tightening making the top for the greenback and the bottom for other major currencies.

Here are some of the themes that we are looking for in 2016:

Monetary policy gaps will expand in the first half and narrow in the second – The Federal Reserve’s rate hike ushers in a new phase of monetary divergence. In the coming year, the Fed will continue to reduce accommodation at a time when other central banks maintain and even expand their stimulus programs. While the Fed will be the only major central bank raising interest rates for most if not the entire year, in the first few months, investors will be actively thinking about who needs to move next. This speculation could accelerate as the strains of low commodity prices, slow growth and weak external demand hits many economies. But at the end of the day for most countries, the bar is high for additional easing. The global easing cycle is nearing an end as long as the Fed raises interest rates responsibility and avoids wrecking havoc on the financial markets. As such we believe that this past year’s dominant trends should continue in the first few months and reverse as the year progresses and monetary policy divergences stop widening. Another way to look at this is that while we expect dollar strength to continue, it should abate through the year.

Commodity prices will find a bottom in 2016. A strong dollar, weak global demand and high inventories have caused oil prices to collapse this year and while prices could fall further in the near term as the U.S. ends its 40 year ban on oil exports and sanctions are lifted on Iran, when the dollar peaks, commodities will bottom. The price of oil could fall below $30 a barrel but we do not see much weakness beyond that and by the end of the year we expect prices to settle closer to $40. In the long run, China’s focus on domestic demand should be positive for energy prices. We expect further easing and a lower currency in the coming year. A bottom in commodity prices would not only affect the outlook for commodity currencies but could also mark a shift in G7 monetary policies as inflation starts to stabilize and turn upwards. Lifting inflation is the greatest challenge for many central banks and while a strong dollar lowers the value of local currencies, it also adds to disinflationary pressure by lowering prices and the question then becomes which has greater impact on growth and inflation -- right now its lower commodities and not a lower currency.

2016 should also be a year of diminishing stock market returns. The era of easy money is coming to an end and the strong dollar along with Fed tightening will take a big bite out of corporate profitability. Single digit gains are the best that investors should expect in earnings growth. The prospect of a persistently strong dollar, sluggish global growth and lower commodity prices in the first half of the year means that earnings and stocks could suffer. We are looking for a correction in equities in early 2016 that could trigger a flight to safety in the currency market.

At many points in the year politics will overshadow economics. We have the U.S. election, the U.K. referendum, ongoing Eurozone refugee crisis, possible showdown with Russia and risk of more aggression by ISIS. The U.S. election is definitely a second half story and while there are a lot of different factors at play this year according to our study, the EUR/USD has a lower bias during U.S. election years. In the 10 elections going back to the 1970s the EUR/USD weakened in 8 out of the 10 periods. The U.K. referendum poses a major risk that we will explore in our sterling outlook while the risk of more aggression by ISIS, possible show down with Russia and the ongoing refugee crisis has the greatest impact on the euro. There’s a lot more to explore and we will do that in the individual currency outlooks but for now, these are some of the most important themes that we believe will dominate trading in the coming year.

Is Buying Dollars in 2016 a Smart or Foolish Trade?

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Is Buying Dollars in 2016 a Smart or Foolish Trade?
<p>
2015 has been a great year for the U.S. dollar but with only 5 trading days left many investors are wondering if being long dollars in 2016 is still a smart trade. December has been a difficult month for the greenback with dollar bulls struggling to maintain control. The Federal Reserve raised interest rates for the first time since June 2006 but instead of appreciating, the dollar erased nearly all of November’s gains. Now many investors are wondering that if a rate hike and hawkish forward guidance can’t lift the dollar, is it foolish to be buying greenbacks in 2016.
<p>
To answer that question we have to understand why investors sold dollars in December. The bet that the dollar would rise in 2015 was one of the world’s most crowded trades and according to the CFTC’s Commitment of Traders report, forex futures traders were busy adjusting positions ahead of the December 16 FOMC meeting. The biggest changes were in euro and yen where investors aggressively cut their short euro and short yen positions. This means that investors started to unwind their long dollar trades ahead of FOMC and based on the price action after the meeting, liquidated further after the rate hike. Buying dollars became a very crowded trade in 2015 and a lot of money moved to the sidelines at the end of the year.
<p>
<strong>This means there’s money to put back into play in 2016.
</strong><p>
Yet positioning was not the only reason why investors bailed out of the greenback. According to the following chart past tightening cycles have not been good for the dollar and this scared many investors. While USD/JPY generally appreciated leading up to the rate hike, on a number of occasions it reversed course after tightening but this cycle is different because the first few months of the year will be good for the U.S. economy and the dollar. The warm El Nino weather and low gas prices will boost consumer consumption, which is already supported by steady job creation, wage growth and consumer borrowing. The Fed also welcomes new hawks to their roster of FOMC voters.
<p>
<a href=”http://www.bkassetmanagement.com/wp-content/uploads/2015/12/FOMC_1.png”><img src=”http://www.bkassetmanagement.com/wp-content/uploads/2015/12/FOMC_1-610x305.png” alt=”” title=”FOMC_1″ width=”610″ height=”305″ class=”alignnone size-large wp-image-8953″ /></a>
<p>
<strong>But first lets be clear, the Fed’s rate hikes will not cause a recession. It may slow the economy in the second half of the year but contraction is highly unlikely.</strong> Some investors are worried that the recent move by the Fed could trigger a recession but there are very few indicators and low oil prices have never caused a downturn in the U.S. Of course that could change as the Fed raises interest rates if they move too quickly. One of the greatest challenges is that higher interest rates do not hit the economy in predictable ways. They take time to percolate and it is difficult to predict the point at which the impact shifts from mild to severe. The quarter point hike is only a small tweak in rates and even if the Fed hikes by another 50 to 75bp next year (which is our preferred scenario), the impact on consumer spending and investment will be limited by the fact that most American mortgages are fixed rate, unlike Europe. Also businesses could view the Fed’s tightening as a sign of confidence in the economy and they could be slow to adjust their investments. So at the onset the biggest impact will be on the U.S. dollar.
<p>
<strong>More Hawks in the Birdcage in 2016</strong> -- The performance of dollar hinges on when the Federal Reserve will raise interest rates again. The next meeting is on January 26-27 and as there’s zero chance that rates will be increased in the first few weeks of the New Year, consolidation in the dollar is likely. However if the Fed maintains an optimistic view on the economy, expectations for a rate hike in March will grow, leading to renewed strength for the greenback. It is important to understand that with each new year comes a new group of Fed Presidents and in 2016 4 votes rotate. Four hawks and 1 dove will replace 1 hawk, 1 dove and 2 neutrals. So the balance swings in favor of more consistent tightening. So while the dollar is rich, we believe the path of least resistance is still in higher in the first half of the year. Our outlook changes in the second half of 2016 when we believe rate hikes and the strong dollar will force the Fed to slow their pace of tightening marking the top for the greenback and the bottom for other major currencies.
<p>
<strong>Election years are good for the dollar.</strong> The table below shows that the Dollar Index increased an average of 5% during an election year with the index rising 8 out of the last 10 periods. In 1 of the 2 years that the Dollar Index declined, the greenback lost approximately 0.5%. While it can be argued that Fed policy is not affected by elections, the time of major monetary policy shifts has often coincided with presidential elections. The second chart was created by the Washington Post and while their data only covers 6 election cycles, there’s definitely a notable trend.
<p>
<a href=”http://www.bkassetmanagement.com/wp-content/uploads/2015/12/Elections_DXY.png”><img src=”http://www.bkassetmanagement.com/wp-content/uploads/2015/12/Elections_DXY.png” alt=”” title=”Elections_DXY” width=”182″ height=”210″ class=”aligncenter size-full wp-image-8982″ /></a>
<p>
<a href=”http://www.bkassetmanagement.com/wp-content/uploads/2015/12/WP_FedFund_Changes.jpg”><img src=”http://www.bkassetmanagement.com/wp-content/uploads/2015/12/WP_FedFund_Changes-610x521.jpg” alt=”” title=”WP_FedFund_Changes” width=”610″ height=”521″ class=”aligncenter size-large wp-image-8980″ /></a>
<p>
<strong>Technically there appears to be a double top forming in the Dollar Index.</strong> However 96 is a fairly significant support level that should hold and we expect the index to make another run for 100 after which it should test the 61.8% Fibonacci retracement of the 2001 to 2008 decline near 102.

<a href=”http://www.bkassetmanagement.com/wp-content/uploads/2015/12/DXY2015.png”><img src=”http://www.bkassetmanagement.com/wp-content/uploads/2015/12/DXY2015-610x288.png” alt=”” title=”DXY2015″ width=”610″ height=”288″ class=”aligncenter size-large wp-image-8981″ /></a>

EUR 2016 Outlook – Forget About Parity

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<strong>EUR 2016 Outlook – Forget About Parity
<p>
By Kathy Lien, Managing Director of BKAsset Management
<p>
Six years after the financial crisis and the European Central Bank is still struggling to turn around their economy.</strong> As recently as December, they increased stimulus in a desperate attempt to revive growth and drive inflation higher. This illustrates how deeply entrenched the slowdown is and how poor of a job Eurozone policymakers have done this past year. In the third quarter, the Eurozone economy expanded by a mere 0.3%. During this same period the U.S. economy grew 2%. Inflation is low around the world but the approximately 10% slide in EUR/USD combined with the full scale QE program launched in early 2015 should have been more effective in boosting inflation, which ran at a 0.2% annualized pace in November – well short of the central bank’s 2% target.
<strong><p>
2016 brings more challenges for the Eurozone economy. </strong>While the ECB is comfortable with the current level of monetary policy they will need to extend bond purchases beyond September 2016. September is only a soft target and we can’t see a scenario where growth or inflation will improve enough 9 months forward to warrant a reduction in stimulus. Also, if inflation and growth do not make significant upside progress, the ECB may need to expand the program in the coming year. The ECB’s decision to provide additional stimulus in December reflected their sense of urgency and their overall concern about the economy. Their efforts are paying off as there have been signs of recovery in the Germany but meaningful risks lie ahead. The prospect of further weakness in emerging markets, particularly China, unstable geopolitical situations in the Middle East and Russia, high unemployment, stagnant wages are just some of the problems posing downside risks for the Eurozone in 2016. Countries in the region will benefit from the new round of stimulus, weaker euro and low oil prices but the benefits will be slow to come. France and Italy have not made much progress in terms of growth and while Spain is doing well it is only the fourth largest economy in the region. The fiscal position of most Eurozone nations is also very weak with only a handful producing a budget surplus in the past 3 years. The largest sector, financials will suffer from negative deposit rates. Debt levels are high and major progress towards reducing that burden is not expected over the next 12 months.
<p>
<strong>The greatest risks for the Eurozone in 2016 are political. </strong>Greece will be back in the headlines as the government struggles to enact reforms and meet the demands of its bailout. According to S&P, the country is still at risk of default. At the same time, migration will be a touchy subject for Europe. In 2015, European nations welcomed millions of Syrian refugees with open arms but the Paris attacks have transformed the attitude within Europe and there are now calls for tighter border controls. These demands will quickly intensify if ISIS stages another attack in the region. There’s no question that there will be attempts and it will be up to European intelligence to avoid another catastrophe. In 2015 Russia’s brazen intervention in Ukraine shattered Europe’s illusion that conflict on the continent was long gone history. The EU was forced to enact sanctions, straining relations with Russia and in the middle of the year, they will need to decide whether the sanctions which last until July, should be scrapped or extended. So between sluggish growth, deepening refugee crisis, ISIS aggression and Russian tensions, 2016 will be full of challenges for Europe.
<strong><p>
As for the currency, forget about parity. </strong> In 2015, many analysts saw parity in sight but euro never reached that level. In 2016 big names such as Goldman Sachs, Deutsche Bank and BNP Paribas still see that target being met. While the prospect of even higher rates in the U.S. and continued ECB stimulus will keep the euro under pressure, parity is nothing more than a headline grabbing target. Experienced traders know that these overstretched goals are hard to reach. We agree that EUR/USD will move lower in the coming year and see 1.05 being tested but weaker currencies drive stronger economies and at 1.05, the Eurozone stands to benefit significantly from the combination of ECB stimulus and a lower euro. When the benefits start to be felt through more consistent improvements in Eurozone data, the ECB will feel more optimistic about the economy and less pressured to increase stimulus and that could mark the turning point for the euro. For now, lets focus on the next 4 to 5 cent opportunity in currency. We expect EUR/USD to test its 12 year low of 1.0459 and then bounce 1 to 2 cents before figuring out where it wants to head next.
<strong><p>
Technically, there’s only 2 important support levels in EUR/USD – the 12 year low of 1.0459 and parity. </strong> If the recent low is broken, it should kick off a quick slide to 1.0000. Taking a look at the longer term chart of the currency, a major top formation can be clearly seen. When EUR/USD broke its 2010 low of 1.1877, there was a quick drop to the 61.8% Fibonacci retracement of the 2000 to 2008 rally. This Fib level at 1.1215 is now resistance and a strong close above this level is needed to reverse the negative sentiment in the currency.
<p>
<a href=”http://www.bkassetmanagement.com/wp-content/uploads/2015/12/EURUSD122016.png”><img src=”http://www.bkassetmanagement.com/wp-content/uploads/2015/12/EURUSD122016-610x368.png” alt=”” title=”EURUSD122016″ width=”610″ height=”368″ class=”aligncenter size-large wp-image-8986″ /></a>

British Pound and the Defining Issues for 2016

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<strong>British Pound and the Defining Issues for 2016
<p>
By Kathy Lien, Managing Director for BK Asset Management
<p>
2016 will be a defining year for the British pound – a year when politics will overshadow economics.</strong> Considering that sterling ended the year near 7 month lows against the U.S. dollar, some of our readers may find it surprising that the U.K. was one of the best performing G10 economies. However according to the latest figures for the third quarter, the U.K. economy grew at an annualized pace of 2.1% which matches the pace of U.S. growth. In contrast the Eurozone and Japanese grew 1.6%, Australia expanded 2.5% and Canada contracted by 0.2%. There’s also very little debate that the Bank of England will be the next major central bank to raise interest rates. Yet sterling benefited from none of this and instead weakened versus the euro, Japanese Yen, U.S. and New Zealand dollars over the past 6 months. Part of the underperformance was driven by U.S. dollar strength but slow U.K. wage growth, mixed data and cautious policymakers has the market looking for rates to rise in 2017 and not 2016. <strong>
<p>
We believe the market is underestimating the Bank of England and the U.K. economy because 2016 should be a year of strong growth.</strong> Consumer spending is the backbone of the economy and sales surged in the month of November. While wage growth slowed, labour force participation rates remain near their highest levels in 20 years and service sector activity is accelerating according to the latest reports. As the labor market tightens and inflation bottoms out, wages should rise as well. Slow Chinese and Eurozone growth poses a risk to the economy and the manufacturing sector but the U.K. is still expected to be one of the fastest growing G10 economies in 2016.
<p>
<strong>From the perspective of growth alone, the Bank of England should raise interest rates in the first half of the year. </strong> However there are 2 primary issues holding the central bank back – low commodity prices and the risk of Brexit. Oil prices could remain low for a large part of the year and as of November consumer prices are running at a 0.1% annualized pace, which is far short of the central bank’s forecast. Considering that the Federal Reserve raised rates with yoy inflation at 0.5%, the BoE may not need to see CPI above 1% before tightening monetary policy but they could be reluctant to do so until there is greater clarity on Britain’s position within Europe.
<strong><p>
The greatest risk that the U.K. economy and the British pound faces in 2016 is Brexit. </strong> What is scarier is that opinion polls show voters split almost 50:50 on whether the U.K. should remain in the European Union. The Paris attacks and the country’s confidence in Cameron’s ability to reform freedom of movement rules for EU migrants played a large role in narrowing of polls but for most of the year, support for staying in the U.K. overshadowed the resistance by only a small margin. Leaving the EU would bring a period of deep economic uncertainty that will hurt consumer, business and investor confidence. The actual cost to the economy is difficult to estimate. Supporters of Brexit say that it would save British taxpayers billions and ease their economic responsibilities to the union. However at the same time, there could be significant costs to trade, investment, and jobs. The answer lies in how the exit is structured.
<p>
If Britain maintains a free trade agreement, pursues very ambitious deregulation of its economy and opens up trade almost fully with the rest of the world, the best case scenario calculated by Open Europe, a UK lobby group estimates that a Brexit could lift UK GDP growth by 1.6% in 2030. However in the worst case scenario where the U.K. fails to strike a trade deal with the EU, Brexit could cost the economy as much as -2.2% in GDP growth. Realistically, the best and worst case scenarios are not the most likely outcomes. Predicting the long term impact of Brexit is nearly impossible at this stage because we don’t know what the terms of the new relationship will be and we won’t know until well after the referendum but in the lead up and immediate aftermath of the vote, we expect significant volatility and most likely weakness in sterling and other U.K. assets.
<p>
<strong>It is not in the Bank of England’s interest to raise rates during turbulent times and considering the greatest volatility for sterling will come in the lead up to the referendum, policymakers could err on the side of caution and forgo a rate hike. </strong>Of course there’s another way to look at this – they could raise rates sooner, which would give them the leeway to cut rates later if the markets collapse. There’s no set date for the in/out referendum – it could be in the second half of 2016 or 2017 which means if the BoE wanted to raise rates, they could do so the first half and avoid conflict with the referendum
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The Brexit vote will be a defining moment for not only the U.K. but all of Europe. </strong> Aside from the political ramifications of shifting the power in the European Council, the EU as a whole would be a less attractive partner. The economic implications are unknown but there could be greater competition between the U.K. and E.U. but ultimately the short and medium term ramification is uncertainty, which is never good for a currency.
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Technically GBP/USD is very weak but there are a number of significant support areas below current levels.</strong> First we have the 2013 low at 1.4814, a level that has limited losses for the currency pair in the second half of the year. Below that is the 2015 low of 1.4566. In order for the downtrend to be officially negated, we need to see a much stronger rally in GBP/USD that takes the currency pair above 1.55. With that in mind, we believe that the wide 1.45 to 1.65 trading range in GBP/USD will remain intact in the year ahead. <p>
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