Since the beginning of June, sterling has taken a leg higher on the back of improved global risk sentiment amid easing lockdown measures and economic resumption. The currency rallied for 10 consecutive days against the USD to a three-month high, the longest rising streak since 2012.
However, a warning tone by the Fed and looming idiosyncratic risks had the currency losing steam thereafter. Stalemate in the Brexit talks as the deadline nears, coupled with the risks of extended lockdown measures into Q3 and growing prospects of negative interest rates, make the case for a shaking pound in the short run.
Even though we remain optimistic on sterling towards the end of the year, the currency is set to be weighed by yet another hectic week in the domestic agenda, with the Bank of England policy meeting scheduled on Thursday 18th.
After the BoE failed to deliver a boost to the asset purchases programme in the May meeting, the bank is left with little choice but to increase the extent of quantitative easing. Earlier in March, the MPC committed to purchasing £200 billion in gilts and corporate bonds, but at the current pace, the programme might run out of gas as soon as mid-July. With the UK economy on course to suffer its sharpest contraction in three centuries, the context is particularly supportive of additional injection of QE firepower, with analysts’ consensus pointing to a £100bn top-up to the asset-purchase facility next week. Additional BoE purchases of government debt are set to be the marginal tool of choice, as per an appropriate environment in which the Treasury issuance remains elevated. Even with these extra purchases, conventional QE limits wouldn’t be compromised as the BoE would still own less than 30% of a rapidly expanding gilt market. Stretched quantitative easing also serves the immediate goal of reducing the back-end funding costs for the government, firms, and households, which is an additional advantage of this policy tool over interest rate cuts.
Nonetheless, under the current set of economic risks, financial markets have recently begun to price a greater probability of negative interest rates in the UK. BoE officials have increasingly emphasised that reducing the Bank Rate below zero is a policy option “under active review” after the benchmark was cut by 65bp to a historic low of 0.10%.
However, we believe that the central bank has several other lines of defense before cutting interest rates further.
While negative rates remain as a policy choice, the particular UK institutional context renders the tool-less suited than in the Eurozone, Switzerland, or Japan. UK lenders are particularly vulnerable to margin compression given their reliance on deposit funding, which could end up constraining the flow of lending to the real economy. There are also operational hurdles to tiering reserve remuneration at the Bank of England, given the prevalence of a single reference rate. Alternatively, the BoE could introduce negative rates -if needed- via an already existing temporary lending facility, instead of shifting permanently to a new regime with challenging tiering operationalisation. A prime candidate in this regard is the Term Funding Scheme (TFS), and its latest version with additional incentives for SMEs (TFSME).
The bar of surprises for the next BoE meeting is relatively high, as markets have already priced in the injection of additional QE. Beyond that, we see limited scope for a reduction in the interest rate on the Term Funding Scheme as soon as in the June meeting, although it is set to be the next policy tool of choice, especially if the fiscal policy turns less proactive. Regarding a fully-fledged system of negative rates on bank reserves, we see it marginally unlikely unless the UK economy is hit with another shock, i.e, a second wave of contagion triggering further lockdown measures or the threat of potential trade barriers. The options market currently prices a one-in-five chance that Bank Rate will be negative in twelve months’ time.
Sterling halts a rising streak as idiosyncratic risks remain in scope
EU leaders set to meet next week to discuss details on recovery fund
The 19 finance ministers of the euro area held a videoconference on June 10th to discuss the details of the EU’s massive coronavirus stimulus package. The meeting came after Eurogroup chief Mario Centeno resigned from the Portuguese government where he had served as a finance minister for the past five years. As being a finance minister is a requirement to serve as Eurogroup chief, this means that the Eurogroup will have to look for a new president. The search for a president comes at a time when the EU faces its deepest recession in history, caused by the pandemic.
To counter the economic downturn, the EU proposed an unprecedented €750 bn recovery fund. The Next Generation EU fund, which is meant to address the eurozone’s main financing needs, consists of €500 bn delivered as grants and €250 credited as loans.
However, three key hurdles need to be addressed before the plan can be signed off and implemented:
- Grants or loans? The idea of overloading the recovery fund with grants is not welcomed by all EU members, as some fiscally conservative nations such as Sweden, Holland, Denmark and Austria oppose raising new debt with limited returns for their input. In addition to this, Finland reportedly asked to increase the share of loans compared to grants, while suggesting for a lower amount to be borrowed as a whole.
- The distribution of funds. The initial proposal by the European Commission suggested that the grants should be allocated based on a pre-defined allocation key which considers population, GDP per capita, and unemployment. This proposal was criticised by some as the data is backward looking and does not consider which countries have been hit hardest in the current crisis, but waiting for more data to be collected would not allow the EC to allocate the funds urgently.
- How to monitor the use of funds. As a way to oversee the use of the funds, the EC suggested that member states should outline their reform and investment priorities up until 2024, to allow tracking what the recovery fund is being spent on. However, as this does not fully erase the risk of misuse, the EC may have to use other mechanisms to monitor the use of the fund.
The 27 EU leaders will discuss the €750 billion plan next week on Friday 19th, but this is expected to be a preliminary meeting with another high-level discussion needed in the summer months. Market expectations for any progress after next week’s meeting may be limited after a spokesperson for the European Council president, who chairs the EU summits in Brussels, downplayed expectations of a breakthrough. The spokesperson stated that the meeting “will be a thorough preparation for the next summit at a later date which should if possible be a physical meeting”. Vice-President Valdis Dombrovskis stated earlier this week that although it would be very good to have a political agreement in July already, this is set to be Herculean task. The EU leaders already failed to reach an agreement on the budget in February, when the EU economies were nowhere near the state that awaited them in the months to come, as the pandemic only further widened the gap among the national capitals.
Any developments in this front, however, could likely trigger some EURUSD volatility. Previous announcements on the stimulus plan had the euro reacting positively, as a substantial and coordinated fiscal response may be just what the eurozone needs.
As expectations for the meeting remain low, any progress in the plans going ahead could further induce a sustained euro rally like the one not seen since the announcement of the proposal last month.
EURUSD nears 1-year high ahead of EU finance ministers meeting on the recovery fund proposal
Olivia Alvarez Mendez, FX Market Analyst
Ima Sammani, Junior FX Market Analyst