US & UK PMI ‘Scream Uncle' on the exchange rate

New Month but old story in the financial markets. Risk aversion in the equity markets across the globe witnessed on Tuesday was once again blamed on China. Apart from all the ‘red’ colour at equity and commodity markets across the globe, the other major piece of information was the final manufacturing PMI reports in the US and the UK.

First, let us have a look at the final UK manufacturing PMI report. The index dropped to 51.5 in August. But more important was the negative effect of the Sterling exchange rate on the inflow of export orders. I have pointed out repeatedly in morning reports since May that the Sterling exchange rate is dragging export orders lower and sooner or later it will drag the GBP lower as well.

The August report said, “The domestic market remained the main pillar of new order growth, as the level of new export business decreased for the fifth straight month. Companies linked reduced overseas demand to the sterling exchange rate, weak sales performance to the Eurozone and the slowdown in China.”

Average costs also dropped due to –“a combination of lower oil prices, the sterling exchange rate and reductions in the costs of a wide range of raw materials.”

Now let us look at the US ISM manufacturing PMI, which registered 51.1%, a decrease of 1.6% points from the July reading of 52.7%. The official report from the ISM also revealed, “ISM’s New Export Orders Index registered 46.5 percent in August, a reduction of 1.5 percentage points relative to the 48 percent reported in July, indicating the third consecutive month of decreases in new export orders. The New Orders Index registered 51.7 percent, a decrease of 4.8 percentage points from the reading of 56.5 percent in July.”

The Markit US manufacturing PMI dropped to 22-month low in August. The details once again reveal the negative impact of the strong US dollar. The official report said, “Export sales decreased slightly in August and the rate of decline was the most marked since April. Lower levels of new work from abroad were partly attributed to the strong dollar.”

Clearly, a stronger USD and a stronger GBP – (especially against EUR) is weighing over the export sector in both the countries. Interestingly, the Fed and BOE are expected to hike rates going forward. Fed is still expected to begin in 2015, while the BOE rate hike is expected to happen in early to mid-2016.

If we look at German PMI, the picture is polar opposite and not surprising at all. Manufacturing PMI in Germany rose to 16-month high. The report also says, “new business from abroad rose in August, following a marginal decline in the previous month. Panel members noted increased new orders from the Middle East and the US.”

Naturally, it is quite logical to expect that Fed and BOE would downplay rate hike expectations and kill their respective currencies, which could turn the current picture polar opposite. However, it is easier said than done; especially for the Fed.

US and UK sold as bright spots since Q3 2014

The rate hike story, especially in the US has been sold as a net positive for the US and global economy. An argument like – rates are being hiked to avoid overshooting inflation target or avoid overheating. Consequently, the US is viewed as a “one bright spot” in the global economy and the one which shall eventually pull other nations out of trouble. Markets, thus, stayed buoyed after QE went off the table and rate hike talk began. Slowdown in China has been evident for a couple of years, EU crisis was back on the wires, commodity - crude prices dropped sharply; still markets remained strong due to optimism about the US economy.

No Fed rate hike could lead to an immediate crash in equities

More than a symbolic move, a Fed rate hike may have become a necessary thing to ensure the markets remained optimistic and an immediate crash is avoided. However, more than one rate hikes are ruled out due to the negative impact of a strong USD on export orders. Domestic consumption is far from recovered and thus, multiple rate hikes could push the economy back into recession. The PMIs could drop below 50.00 due to a sharp slowdown in export orders. In no time, that could also hurt the labor market.

Thus, a single Fed rate hike this year or early 2016 followed by a painful U-turn is likely to unfold over the next year or so. Post the U-turn markets may correct/crash, but a single rate hike is likely to postpone the crash by a few months. Fed’s U-turn later is likely to be followed by QE 4 talks (https://www.fxstreet.com/analysis/macro-scan/2015/07/01/), thus, ensuring markets don’t crash, but only correct in a substantial way.

Its not about China..

Everyone blamed China for the risk aversion today. However, one look at US index futures tells us that it is more about the delay in the Fed rate hike being a negative sign. The US futures were trading in the red in Asia on Tuesday much before weak China PMI hit the wires and led to risk aversion.

Bearish outlook for GBP/USD

• The cable could drop to 1.48 levels in the couple of months. Delay in the Fed rate hike also reduces the probability of the BOE rate hike. Moreover, speculation of a delay in Fed rate hike is mainly due to the turmoil in financial markets that leads to winding of carry trades and spike in EUR/GBP (and weighs over GBP/USD as well).

• On the other hand, a rate hike by Fed would hurt EUR/GBP, but shall any ways push GBP/USD lower. Consequently, the spot could target 1.48 levels in a couple of months.