New Year, New Headwinds For Sterling

Happy New Year to you!

GLOBAL VACCINE HOPES, TRUMP NEAR-TERM FEARS There has been a significant number of developments since our last publication in late December. The key driver in financial markets has been expectations of a bigger US fiscal stimulus package after the Democrats won the two Georgia Senate seats and effectively took control of Congress in addition to Joe Biden winning the presidency. That has supported the so-called ‘reflation trade’, with benchmark US 10-year Treasury yields rising above 1% and global equities tracking higher. Far from pushing back on increasing yields, a number of Federal Reserve officials have indicated that the rise reflects better economic growth prospects and that a ‘tapering’ of bond purchases may even begin late this year or in early 2022.

Underpinning positive risk and economic sentiment have been hopes that a successful rollout of vaccines will eventually lead to a move towards some semblance of pre-Covid normality. In the UK, a new variant is resulting in a very serious escalation in infections and hospitalisations, but vaccinations to the elderly, the most clinically vulnerable groups and frontline workers in health and care homes – which have represented the bulk of fatalities – is underway. The government is targeting about two million jabs a week to reach about 13 million by mid-February, with the hope that lockdown restrictions can start to be eased soon after.

Until that point is reached, UK economic activity is likely to remain suppressed by containment measures. There are indications that the economic impact of the latest lockdown measures (with a third national lockdown in England) is less severe than the first closures last spring, but higher than the second lockdown in November Hence, an expected contraction in UK Q4 GDP now seems likely to be followed by a further decline in the current quarter. A similar situation exists in many countries in Europe, while US economic activity has helped up better, although jobs fell by 140k in December, the first decline since April.

NEGATIVE UK RATES SPECULATION

In the currency markets, positive risk sentiment has maintained broad downward pressure on the US dollar and other safe-haven currencies such as the Japanese yen, while the Norwegian krone has outperformed. Brent crude oil rose to $55 a barrel, while industrial metals prices have also increased.

Sterling has been a notable underperformer this year, as investors shifted their focus beyond the risk of a Brexit ‘no deal’ scenario. The EU-UK Trade and Cooperation Agreement (TCA) was signed late last year, but it remains to be seen how well businesses will adapt to new procedures. The Bank of England has previously indicated that a post-Brexit deal would introduce trade frictions and could temporarily reduce economic activity in the first part of this year. Meanwhile, the pound has also been weighed down by speculation in markets that UK interest rates could be reduced from the current 0.1% level into negative territory. Financial markets are currently pricing in a move to -0.1% by August.

That speculation means that attention will be on speeches by MPC members next week. Previously Silvana Tenreyro has indicated her openness to supporting a cut in interest rates below zero, which would more likely stimulate the economy if mitigating measures such as tiering are introduced to offset potential negative effects on the profitability of financial institutions. Tenreyro is scheduled to speak about international evidence on negative interest rates (Mon 2pm GMT), while Ben Broadbent speaks on “Covid and the composition of spending” (Tue 10am).

Official UK November GDP data will be released on Friday. Although backward looking, the figures will reveal the extent to which the second national lockdown in England affected activity during the month. We tentatively forecast a month-onmonth decline of -4.0%, with weakness concentrated in services activity, as pubs, restaurants, gyms and non-essential shops closed. While the fall is predicted to be considerably less than during the first lockdown and activity in December is likely to have picked up as restrictions were eased, negative growth is still expected for the quarter as a whole.

US CPI, RETAIL SALES, CONSUMER CONFIDENCE

In the Eurozone, the publication of the minutes of the ECB’s December meeting (Thu) could provide further clues on the monetary policy outlook. That meeting saw an expansion of the Pandemic Emergency Purchase Programme (PEPP) to €1.85 trillion, while downside risks were described as ‘less pronounced’. Still, uncertainty about the outlook remains high, with containment measures in the near term looking to be in place for longer than anticipated. Germany will release GDP (Thu) for 2020 as a whole, which we predict will show a fall of 5.1%.

The US data focus will include CPI inflation (Wed), weekly jobless claims (Thu), retail sales (Fri) and the University of Michigan consumer sentiment (Fri). Annual CPI is expected to rise to 1.3% in December on the back of higher energy prices, but it will still be below the Fed's target. Retail sales have fallen in the last two months after a strong summer and early autumn, primarily because of a slide in car sales. There are some tentative signs that they picked up in December, but nevertheless we still looking for overall sales to be flat. Finally, concerns about the end-year acceleration in Covid cases may have caused consumer sentiment to slide in the New Year despite the start of the vaccine rollout. We forecast the headline index for January to decline to 79.0.

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None of the information in this article is, nor should be construed as, financial advice. All foreign exchange transactions involve risk and you should always seek your own independent financial advice before entering into any foreign exchange transaction.