Tags: Scotland | UK | pound | ECB

September Is Starting Off With Fireworks

By    |   Tuesday, 09 September 2014 09:02 AM

We certainly can say that September has started with a couple of interesting and even unexpected fireworks causing direct impacts, especially on the foreign exchange markets.

The first one came on Thursday from the European Central Bank (ECB) and then over the weekend we got the publication of the latest polls on the vote intentions for Scottish independence that will take place Sept. 18.

Between these two events we got on Friday in the United States a firecracker with a disappointing rise in nonfarm payrolls to only 142,000, after a 212,000 increase in July and 267,000 in June. Both June and July were revised downward by 28,000. We also saw the unemployment rate coming down to 6.1 percent from 6.2 percent, but that was caused by a smaller workforce.

These data, it must be said, weren't bad, but since they came with a commensurate lack of wage pressure the whole situation will play directly into Federal Reserve Chair Janet Yellen's view that there is still too much slack in the job market. This will probably prevent the Fed to abandon its "extended period" wording in its Federal Open Market Committee (FOMC) statement on Sept. 17 after the Fed will have cut further $5 billion of mortgage-backed securities purchases and $10 billion in Treasury securities for one last month.

I don't think it's an overstatement to say the Fed is closing in on the day when it will finally have to face the white elephant that will represent the use of clear language about the policy process it will apply after quantitative easing has come to an end.

Next week the Fed will also provide a summary of its economic projections, which could be enlightening. After the release of the FOMC statement, Yellen will hold a press conference where, let's hope, we will get a little bit more clarity on how the Fed sees the use of floor and ceiling boundaries that will further define its targeted levels for short-term rates.

Keep in mind, the Fed could and probably will establish a target range, similar to the 0 to 25 basis points range (bps) range, which it currently applies for short-term rates. A move to 25 to 50 bps is in the cards in the not-so-distant future and should not be in contradiction with the Fed's wording of "low for longer." We'll have to wait and see, but it could become interesting to see how the different markets will react the day the wording finally changes, especially now that we see an extension of negative euro interest rates at the ECB and negative yields in some eurozone government bonds. The eurozone apparently is irrevocably on the road to the "borderland" zone of the 1 percent growth and 1 percent inflation for a long time to come, which means in simple words, it's not a good situation to be in.

On Thursday the ECB cut all its applicable interest rates by 0.1 percent, which brought 1) the rate for refinancing operations of the Eurosystem to 0.05 percent; 2) the rate on the marginal lending facility to 0.3 percent and 3) the rate on the deposit facility to negative -0.2 percent. This should help to push the euro lower. The ECB hereby, willing or not, becomes participant of the ongoing currency wars.

All this brought the ECB further into unchartered territory and further away from the German Bundesbank model.

The ECB Governing Council also decided to start purchasing non-financial private sector assets. The Eurosystem will 1) start purchasing a broad portfolio of asset-backed securities (ABSs) and 2) purchase a broad portfolio of euro-denominated covered bonds issued by Monetary Financial Institutions domiciled in the euro area. Both programs will start on Oct. 24.

Now, everybody hopes all goes well and the eurozone doesn't get trapped into a Japanese-style permanent recession and deflation because, if that would be the case, the ECB would have to face huge losses. It's as complicated and as simple as that.

In my opinion, we could be witnessing a stealth Eurobond operation wherein the ECB will first only buy the safest of the risky assets that conform to its own criteria. However, in 2013 there were only 38 billion euros, or approximately $49 billion, ABSs issued in the eurozone, which is way too small to play an effective role in the ECB scheme. Therefore, the ECB could end up buying eurozone government bonds directly, which would then complete the circle of what we could call a functioning but stealthy Eurobond system.

The big question remains if Germany and a couple of other states would be willing to accept that. If all goes well, of course there is no trouble to be expected. If not, then we could expect another very serious crisis in the eurozone.

Finally, the political surprise with direct impact on the foreign exchange markets came from Scotland over the weekend. The U.K. Sunday Times published the latest poll on the referendum on Scottish independence by YouGov showing that for the very first time 51 percent of the people surveyed, after the undecided voters were stripped out, were now for the independence of Scotland. It was also interesting to see that 35 percent of the "Yes" voters were "Labor" voters.

As things stand today, we could call the Scottish referendum outcome a situation that is too close to call, but if there is a "Yes" vote that wins the referendum on Sept. 18, the financial markets, especially in the United Kingdom, will have to take into account a whole range of uncertainties for a very long time to come. Of course, there is the use of the British pound, the "who owns what" in the U.K. debt portfolio, the ownership of the oil fields in the North Sea and what will be the impact on the British companies that have significant cross-border operations.

Believe me, it will also be complicated if the "No" vote wins only by a slim margin.

But, and this is important for long-term investors who have long-term exposures to the British pound, whatever comes out of the referendum, there is a substantial risk that the British pound will come under great pressure and experience sharply increased volatility.

To keep it simple and since the British pound is certainly not a "yoyo" currency, we could look back to three recent periods where we have seen sharp movements in the British pound:

First: On "Black Wednesday," Sept. 16, 1992, the United Kingdom abandoned the European Exchange Rate Mechanism (ERM) because it was unable to keep the pound above its agreed lower limit in the ERM, the pound fell 16 percent in three months. By the way, it was in that period that Georges Soros made more than 1 billion pounds by "shorting" the pound.

Second: When on May 1, 1997, Tony Blair and the Labor Party won a landslide victory in the general elections in the United Kingdom, the pound rose 22 percent in 11 months.

Third: After the collapse of British bank Northern Rock in 2007, the pound lost 29 percent in 15 months.

Now, when we take the average of time and percentage moves of those three periods we get an average of 22 percent in nine months. The British pound normally doesn't move abruptly, but when it does, fasten your seatbelts. And when it moves now it will be down!

I'm not saying it "will" happen this time around, but I wouldn't be surprised if it did. As a long-term investor, I'd try to hedge my pound sterling risk exposure, in case I'd have British pounds in my portfolio.

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We certainly can say that September has started with a couple of interesting and even unexpected fireworks causing direct impacts, especially on the foreign exchange markets.
Scotland, UK, pound, ECB
Tuesday, 09 September 2014 09:02 AM
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