All talk, not much currency action
Investors couldn't help notice the impasse in negotiations over Nafta, Brexit and Catalonia, but did they care very much? Michael Sneyd of BNP Paribas tells Roger Blitz why the foreign exchange market is more interested in central bank developments than talks deadlock
Presented by Roger Blitz and produced by Fiona Symon
Welcome to Hard Currency, the Financial Times podcast on the foreign exchange market. I'm Roger Blitz, and this week has been about the lost art of negotiation and its impact on currency. Talks are getting bogged down everywhere, over the renegotiation of NAFTA, that's the North American Free Trade Agreement, which has created volatility for the Mexican peso, over Brexit, which has pulled the pound lower, and over Catalonia's independence drive, which has had little impact on the euro, but not much.
So in other words, what makes markets sensitive to a breakdown in some negotiations, but not others. With me to discuss this, and other things, is Michael Sneyd, the Chief FX Strategist at BNP Paribas. Michael, I suppose it's the Mexican peso which seems to be more worried than anything else about when talks break down. That's hardly surprising, given the extent to which Mexico is a vulnerable economy. Do you agree?
Yes, if you look back over the last 12 months, we had this period, right after Donald Trump was elected, where Mexican peso and broadly EM currencies underperformed on the basis that there was concerns of increased protectionism and renegotiation of NAFTA. Most of this year, we've seen those expectations unwind.
That combined with high inflation, accommodative policy from central banks, has created a very good backdrop for emerging markets. So I think one of the contributors to the Mexican peso's high volatility is the fact that it's been a very strong performing currency this year.
OK, so that's the peso in a nutshell. But the ongoing Brexit talks and Catalonia, what are the impacts, do you think, on these currencies? Much?
Yes, something I think is very interesting is when we look at how the FX market responds to political headlines, at the moment we are seeing much less sensitivity than we've seen for a long, long time. So particularly if we look around the situation in Spain, and if you can compare that back to 2012, during the European crisis, we see that the sensitivity is very, very diminished.
If anything, actually the other way-- when we look at positioning, how the FX investors are actually trading the euro, at the moment investors are long euros. So that's suggesting that they're looking through this political risk. And actually they're focusing on things like the strong growth in the eurozone, the change of tone from the ECB and the upcoming tapering, and off the back of that, they're actually putting on these long euro positions.
And the same is true with the UK, with the Bank of England, and sterling it's more about whether the bank is going to raise interest rates than it is about the cut and trust of the latest talks in Brussels, is that right?
Yes, the focus very much in the last couple of months has been on the Bank of England rates expectations. And if we look again at what investors in FX markets have been doing, we can see that before we had the Bank of England changed their rhetoric, the market was very short on the pound. So it was focused on some of the uncertainties, the slowdown in growth, and the uncertainty in the Brexit negotiations.
Since, however, the Bank of England changed their tone, we have seen the short selling positions be completely cleared out. In fact, if anything, at one point, a couple of weeks ago, our metric was saying that the market was long pounds overall.
So looking at this week's fall in sterling, it's more about the data, the retail sales, and that, and the general downbeat feeling about the economy, rather than whether it's going to be a two-year transition deal on the table come Thursday.
I think that's precisely the case. And particularly now that the market is holding these slightly longer neutral positions in sterling, that really sets sterling up for a fall. Because if we see the expectations around the Bank of England start to diminish over the next couple of weeks, then that's going to remove one of the main supporting factors we've seen for the pound.
Where are you on Bank of England? Do you think November is very much in play? You didn't detect a kind of a slight rolling back from Mark Carney this week? He's talking about the next few months for a rate raise.
So us at BNP Paribas, compared to the market expectations, we think there's a lower likelihood that they hike rates than is currently priced in. The reason for that is we're focusing very much on the data that has softened recently. And also something I think is very important is the inflation outlook. Inflation has been pushing higher. But this is largely due to the impact of the weak currency.
Now, there's a lag to a relationship. So we estimate that it takes around about 10 months for the currency effect to feed through to inflation. And it was now about 10 months that sterling was at its weakest level. So what that means is, going forward, what has been boosting inflation from the FX channel, is actually now going to be rolling over and is actually going to be pushing inflation lower. So we think at the moment, inflation is probably around where it's going to peak.
When you talk about you're bearish on the Bank of England, you mean at all, or in terms of timing?
At all, because we think if they don't take the opportunity to hike rates in November, by the time that we get to the next inflation point in February, we think the data is going to soften considerably.
Well, that's heading for quite a drop in sterling if that does happen, doesn't it?
Yeah, that's certainly the case.
You're therefore pricing cable at what?
So we've got cable down to 127 at the start of next year.
OK. Same question for the ECB, what are you pricing in for next week's crucial ECB meeting? What's your expectation?
We're expecting the ECB to reduce the pace of purchases to $30 billion a month. And we expect an extension of just six months. This, I think, is slightly more hawkish than the market expectations. In terms of the euro however, we think that a lot of this is already kind of baked into the price. I was discussing earlier about Europe positioning, the market is already holding quite substantial long euro positions, and we think this limits the ability for the euro to rally off the back of the ECB announcement.
OK, and on the American side, on the US side, clearly there are still big issues to be resolved to determine where euro dollar might move. On tax reform, and on the Fed chair issue, are you bullish on tax reform? We are bullish on tax reform, and that makes us--
You're on your own.
And that makes us bullish on the dollar. And it's largely a sense of we think the market hasn't priced in a very high probability of tax reform being delivered.
You can see why though.
There is a lot of uncertainty ahead. But there's also, if you look at where stocks, particularly stocks that will be sensitive to tax reform, and if you look at the positioning of how investors are trading the dollar at the moment, positioning is very bearish. So when we take into account how the market is currently trading, we think there is not enough optimism around tax reform price [? stasis. ?]
A counterintuitive stance BNP are taking, is that fair? In some respects.
In some respects, but also, you know, we're looking at what we think is likely to be delivered. We're looking as well as what the market is expecting. And at the moment, we think there's a big disparity between the two.
On that theme, we're all kind of looking at what might create a correction to this pretty strong growth and equity story. And we had the Chinese central bank governor on Thursday talking about the potential for a Minsky moment, the possibility that we're all running in this direction and there's just too much optimism around. That does feel like a-- it doesn't surprise us that people might hold that view. But I suppose it's coming from the governor or the Chinese Central Bank, that's going to create some people to sit up and take notice. Do you agree?
I do. I think what's in particular a focus for us, is the amount of leverage that you start to get into risky assets. And that's largely due to the fact that we've been in a very vol environment this year. So when you have low vol, it means that when you look at and evaluate risk measures, the tail risk of portfolios, it enables investors to put more risk into positions. And then that in itself suppresses vol, and you get this vicious circle which encourages more and more risk taking. And I think that is what is being highlighted by some of the officials at the moment.
On the other hand, are we are we at the top in terms of equity valuation, or is there further to go?
So I think with equities, I like to break things down into the components of equities. So if we think in terms of valuations, so things like P/E ratios, these do look quite high at the moment. And that's largely been driven by central banks accommodative policy, pushing up equity prices. But the other bit of the story, which I think is very important, is the earnings story.
Earnings have been moving dramatically higher across the globe over the last 12 months. This is very supportive for equities. Going forward, we see that this type of economic environment, where growth is strong and inflation is just starting to pick up, is actually very good for corporate profit margins. Because it enables them to start to raise prices. And that, I think, could be a supporting factor for equities going forward.
The equity rally is not over yet.
Michael Sneyd, thank you very much. That's Michael Sneyd from BNP Paribas. Next week, there'll be lots to digest. We didn't have a chance to talk about Japan's election result this weekend, but that will be one of them, and that crucial ECB meeting is clearly the other. Join us again for Hard Currency. Until then, it's goodbye.