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OPINION

Come what May

Come what May
June 16, 2017
Come what May

As is always the case, the markets react first and ask questions later, exchange rates being global and 24-hour often reacting the most violently. However, foreign exchange (FX) is always a relative equation, not an absolute, so one must factor in what's happening on the other side of the equation. Sometimes interest rate differentials matter, at other times they don't; economic prospects matter, but only over the very long term. Inflation always matters, although the effects of a deflationary environment are not well documented.

Terms of trade, as well as the value of the currency will affect balances between nations. In 2015 the UK imported £61bn more than it sold (in goods and services) to the European Union. Germany's the biggest beneficiary, with a £25bn surplus, followed by Spain at £10bn and then Belgium, the Netherlands and France with between £5bn and £8bn apiece. In the first quarter of 2016 the EU trade deficit ballooned to a new record high at £24bn; you can see why they want tariff-free trade.

Cable (sterling versus the US dollar) slipped on the election result, but this was a fraction of the slump post-referendum. Technically, however, it suggests that an uneasy truce is likely to dominate until the year-end, capped around the psychological $1.3000 and cheap around $1.2000.

 

Pound/US dollar

 

Against the euro we're currently trading roughly halfway between the referendum's slump to £0.9300 and subsequent strength at £0.8300. Anything above £0.9000 should be considered as relatively cheap and, depending on how Brexit negotiations go, the trade deficit with the EU is likely to shrink. Therefore, over the very long term an equilibrium rate closer to £0.7800 might be achievable.

 

Euro/sterling

 

The Bank of England's Bank Rate will probably hold at its record low 0.25 per cent because, come hell or high water, it will be expected to help the British economy pull through and survive what are likely to be gruelling times. Because of this, over the next two years gilt yields are likely to drift towards this point as fund managers and investors realise that some interest is better than no interest; in other words, an even flatter yield curve. However, this might be nigh on impossible to maintain were retail prices index inflation to spike above 5 per cent (currently 3.7 per cent and consumer prices index inflation now 2.9 per cent).

 

10-year gilt yield

 

As for the FTSE 250, which more accurately reflects the UK economy rather than the FTSE 100, its stellar performance since 2016's low might be hard to maintain. A small but potential topping pattern has been forming since late May, hinting that on a break below trend line support, a correction's due.

 

FTSE 250