The market backs Boris as pound reaches three year high

The pound is in demand this week as Indyref2 fears fade into the background, but can US and CHinese price pressures shock financial markets. 

This time last week there would not be many people who would have predicted that a key driver for global markets would be the fall-out from a set of UK local elections and a terribly weak set of US payrolls data. But it is often difficult to predict what will happen with financial markets and what the drivers will be from one week to the next. We are now in a position where fears about inflation are rising in the corporate sphere; inflation was mentioned heavily in Q1 2021earnings reports, however Treasury yields are falling. This could make it an interesting summer for financial markets. 

Scottish referendum prospects bleak in the short term 

In the UK, the Conservatives have tightened their grip on power after a victorious weekend for local election results. While Labour predominantly held onto England’s mayor positions, the Conservatives won 253 council seats, and 13 councils, while Labour lost 322 seats and lost 8 councils. The key takeaways from these elections are that Brexit realignment continues, the Tory party is now hegemonic in much of England, Labour has more problems than Jeremy Corbyn and the Greens are on the rise, although they are not a threat, yet, to the main parties. For financial markets, the Tory stronghold over power in the UK is a sign of political certainty. After 5 turbulent years of Brexit, this is welcomed, hence it is no wonder that the pound was on the rise at the start of this week. Added to this, although Nicola Sturgeon continues to say that another referendum on Scottish independence is the will of the Scottish people rather than a demand of the SNP, last weekend’s results suggest that the prospect of a referendum is a long way into the future. The SNP fell one seat short of a majority at Holyrood. While this does not mean that a referendum won’t happen, we do not think that there will be one by the end of this Parliamentary session, which comes to a close in 2024. It is worth noting that combined with the Greens, who have 8 seats at Holyrood, there is a majority of MSPs in favour of independence. However, Boris Johnson has said that there won’t be a referendum in Scotland, not that his view would matter too much if Sturgeon was to push through with a referendum. The biggest problem for Sturgeon is that although a majority of Scots may have voted for pro-independence parties, they have not voted for pro-independence candidates. This means that on a constituency basis only 49% of candidates that won were pro-independence, compared to 50.1% pro-independence on the list vote. While it may seem like Scottish independence is on a knife edge, this still leaves plenty of room for argument as to the whether or not the election did actually register a majority for holding another referendum on Scottish independence. 

Scotland stays part of UK for now, which is good for the pound 

From a political perspective, this could be why Sturgeon has expertly swerved questions on the timing of any potential indyref2, and instead said that her focus must be on battling the rest of the Covid crisis. It is also interesting that incumbents have performed well all over the UK, suggesting that the successful vaccine rollout is one of the reasons that Sturgeon’s SNP held on pretty well to power in Scotland, rather than a vote for the SNP being a pure vote for indyref2. From a financial markets’ perspective, it suggests that the pound is safe from the ramifications of a break-up of the union at least for the next few years, which is a long enough timeline for FX traders to regain faith in the pound. Thus, in a world where crypto currencies are stealing most of the limelight, there is still room for traditional (or old fashioned) currencies to dominate the markets. Overall, the FX market did not like Brexit, which is something synonymous with the UK leader, however, now that Brexit is in the rear-view mirror, the markets are quite taken with Boris. Thus, we believe that the solid Tory political base is a good springboard for future pound gains, and it is one reason why we believe that GBP/USD could hit $1.50 by the end of this year. 

US jobs recovery on hold as dollar nose dives 

The dollar, on the other hand, is likely to struggle to gain traction for the rest of this quarter as Treasury yields remain muted. There is a strange trinity of events taking place in US financial markets right now: bond yields are moving sideways, the 10-year Treasury yield is currently at 1.6%; and the dollar is moving lower and is currently at 90.0 as concerns about weaker payroll data, NFPs expanded by 266k last month, keep a lid on dollar strength. The last part of the trinity is US stocks – although US stocks are lower today it is likely to be a reaction to the S&P’s record high that was reached on Friday. Thus, weak economic data is unlikely to impact stocks as long as it keeps a lid on bond yields. Of course, last month’s payroll data could have been a blip, and we could see a big number for May, however, there is no doubt that April’s weaker than expected payrolls report is making investment decisions in the US that bit harder. 

Interestingly, at the start of this week, the Nasdaq is down some 2%, and is testing a key technical level, the 50-day moving average at 13,536. This contrasts with the Dow, which has reached a fresh record on Monday, suggesting that the rotation out of mega caps and into cyclical stocks that mostly find their home in the Dow Jones index is continuing to take place today. This also helps to explain the slight uptick in US Treasury yields and also suggests that the market continues to see a strong recovery for the US economy, even if payrolls were a big disappointment for April. Thus, April’s NFP figure may not dominate markets as we progress through May. 

What to watch this week 

Events to watch this week include Chinese inflation data, a strong increase in producer price inflation could hurt risk sentiment as we progress through the week. The UK’s GDP for March is expected to be a decent 1.3%, which is good considering the country was still in lockdown. A strong March GDP reading could give more oomph to the pound rally that is taking place this week. Elsewhere, German ZEW and US inflation are also worth watching. The latter is expected to show a sharp rise in prices to 2.3% YoY for core consumer prices. Don’t expect any action from the Fed, firstly they will allow inflation to run hot after last year’s economic shock, and secondly, they expect this spike in inflation to be transitory. If inflation is still spiking in October then the Fed may be forced to act, for now though, it is likely to remain in accommodative mode.