By Stuart Cole, chief macro strategist at Equiti
Only two weeks ago market talk was about how high cable might trade. Views were given that a return to pre-EU referendum levels by end-year was feasible; other calls saw 1.5000 over the same period. But since then, cable has retreated, trading down to 1.3780 before recovering some ground. The heady heights of late-February seem like a moment of market over-exuberance.
This weakening has raised suggestions that the outlook for cable was never as positive as the pro-sterling camp was suggesting, that the economic damage from Covid-19 and Brexit had rendered the UK structurally weak, leaving cable vulnerable to trading lower. This raises the question, does cable retain the capacity for further upside gains?
A key issue is whether the current dollar strength represents the start of a new trend or something more transient. The recent rise in yields has certainly provided an unexpected source of dollar support. Predicated on rising optimism regarding the US economy, it would be easy to conclude higher yields will persist going forwards, continuing to underpin the dollar. However, this may not necessarily be the case. Although the Fed has so far appeared sanguine to this financial tightening, whether it will allow yields to climb significantly higher is debatable. Its view remains that the economic recovery is fragile, requiring support. Higher yields will simply act as a drag on growth, weighing on the booming housing sector, threatening investment spending, keeping unemployment elevated and presenting the Federal Government with an ever-increasing debt servicing cost. Accordingly, there is likely to be a tipping point where the Fed will step in and attempt to take back control of the yield curve, for the express purpose of keeping yields low and in turn seeing the dollar weaken.
A second issue concerns the actual strength of the US recovery. Undoubtedly evidence suggests the outlook is improving, given rising PMI/ISM numbers, stronger retail sales, increasing confidence etc, and February’s employment report very much cemented this narrative. However, the positivity this release generated appeared to overlook the fact that total non-farm payrolls remain over 9 million lower than pre-pandemic levels, with the numbers of long term unemployed actually rising to 4.15mn, the highest level since 2013. This statistic will concern the authorities and until progress is made in reversing it, the Fed will be unwilling to counter a material policy tightening, especially given its view that the labour market will act as a natural dampener on inflation.
Lastly, the Biden Administration has grand spending plans, with a $1.9tn stimulus package ready for dispersal and more spending initiatives in the pipeline. This latest package represents approximately 10% of US GDP and will add to an already large debt stock of some $28tn, and one which is rising fast. Already standing at 130% of GDP, the market is so far showing it retains confidence in the dollar. But at some point, this confidence could wane, potentially threatening the dollar’s dominant role in global finance and almost certainly seeing it trading lower: debt of 160% of GDP was enough to trigger the Greek financial crisis in 2009.
On the flipside to all of this, of course, is the UK, where sterling’s weakness suggests a deterioration in the economic outlook. But this outlook remains upbeat. Progress with covid vaccinations remains impressive allowing lockdown restrictions to be eased, market expectations of interest rates have reversed, Brexit uncertainties have dissipated and plans to reduce public borrowing have been outlined by the Government, suggesting the worst of the pandemic has passed. Overall, a positive picture.
Accordingly, the conclusion is that cable’s losses are largely a US story, the dollar responding too fast to an economic recovery that still poses questions. In contrast, the slower recovery sterling has exhibited towards the improving UK outlook suggests a more solid foundation going forward, one that offers cable a strong base from which to resume its uptrend.