Brexit Stalls, but Slumping Forex Volatility Suggests Major Moves Imminent

Tom Cleveland

The political powers that be in both the UK and the EU have kicked the “Brexit can” down the road again, this time setting the end of October, as the next time we can expect some attempt at a resolution of this fiasco in action. In the meantime, the forex market is once again held in abeyance, unclear as to what direction is the correct one under these new circumstances. The U.S. Dollar, the Pound, and the Euro have been hovering between rather tight ranges for months, while volatility slumped to lows not seen since 2014.

Jeremy Stretch, head of Group-of-10 currency strategy at CIBC in London, summed up expectations on Bloomberg radio: “As we start to move into the middle and second half of the year, markets will need to reassess their assumptions. That may well bring forth a degree of volatility back into the market.” There are a few market adages that come to mind that also apply to foreign exchange. A bit of paraphrasing suggests that the longer the ranging behavior and the lower the volatility measurements persist over time, the greater the breakout will be in the near term, proportional to a degree to length of the ranging period in question. When ranging and low volatility occur together, watch out.

usd index

The story of the USD index, although not one that the Trump administration wants to hear, has been one of a gradual strengthening, due primarily to monetary policy divergences that refuse to go away. While the Fed normalizes, the rest of the major central banks around the globe refuse to join in, an expectation that was the general underpinning of this year’s economic narrative. In reality, the USD has been range bound, as depicted in the chart above, but it keeps pounding on the 98-doorway.

If you were to check out the “GBP/USD” daily chart for the same 2019 period, it would look almost identical to the above. The market expected the Bank of England to commence with normalization activities, presuming that Brexit had been dealt with, but all is now up in the air. As for the “EUR/USD” pairing, its ranging behaviors since February would have looked identical to both other pairs, but, prior to that month, the Euro had been on a downward track preceding this current ranging motif.

Articles are already appearing that suggest that we should be “preparing for something big.” The direction that the supposed breakout will take is not a given, although the odds tend to favor a continuance of whatever trend preceded the stall. That would be up for both the USD and GBP, but down for the EUR. Such a move might correspond to what pundits are already claiming to be what the EU officials want, i.e., for there to be another public referendum on Brexit, so that the UK populace can vote this time to stay.

Brexit update and where is the Pound going to go?

EU officials may have celebrated when they heard about the latest straw poll taken by Reuters: “The chances that Brexit will be cancelled are now greater than the chances Britain will leave the European Union without a deal, according to economists in a Reuters poll, who again pushed back their expectations for when the Bank of England will raise interest rates.”

An anonymous poll is one thing, but not everyone is in agreement with calling off the effort of the past two years and reverting back to some semblance of normalcy. The economists at PNB Paribas has this to say: “Apart from the fact that no-deal Brexit is now less likely, the path ahead is as unclear as ever. A deal (and likely a softer Brexit) still seems more likely than not. But we are skeptical that this will happen any time soon.” When quizzed, economists on this side of the debate felt that the conclusion might be a simple free-trade deal.

As for the current status, Theresa May has been voted down three times. No one in Parliament, except for a small minority, is willing to go along with her plan for withdrawal, which she had gained approval for from the EU. The March deadline came and went. May obtained a two-week extension, which also came and went, and then EU officials chose the end of October, as the next focal point, in the hopes that the electorate and members of Parliament might get up the nerve to hold another “Stay of Leave” referendum, an option no one was giving any odds of happening a few months back.

With so much up in the air, everyone has backed away from their expectations that the Bank of England will finally begin to take its initial steps toward normalization. According to Elizabeth Martins at HSBC: “Without Brexit uncertainty, the Bank of England might have considered raising interest rates at the May 2 inflation report meeting. With the country still in limbo politically, this is highly unlikely.”

As for the British economy, it has dodged a post-Brexit referendum recession bullet, but the uncertainty has produced slow growth and retarded investment. Job growth has been greater than expected, but the knock on this growth has been that the new net jobs are low paying and of the temporary type that can be eliminated quickly, if things suddenly turned south. The general consensus going forward: “The economy is predicted to grow a modest 0.2 to 0.4 percent per quarter through to the end of next year, similar to forecasts for the euro zone.”

What will happen to the Pound, as the EU plays its waiting game? One currency and commodities expert, Andrew Hecht, posits this view: “Currencies hate uncertainty. The price action in the British pound since June 2016 tells us that the currency will move higher when a final decision provides a certain future. At this point, I believe that either the UK will capitulate and take the deal on the table or decide to remain part of the EU perhaps with some minor concessions. The next move of the EU could be to provide some carrots for the futures if the UK goes back to the polls, which could swing the vote to a future EU that includes the UK. In either case, a solution would likely cause the value of the pound to rise versus the US dollar if the trading pattern over the past three years holds.”

gbpusd weekly

The historical record that Hecht refers to is borne out in the above weekly chart for Pound Sterling versus the USD. From 2016 forward, it has been on a rollercoaster ride. The market may have overreacted early on to Brexit, but it slowly regained what it had lost, only to react once more to the uncertainty at hand. If a smooth Brexit is achieved, will the Pound revert back to the 1.60 glory days from 2010 through 2014, or even to the heights of 2.00 back in 2007?

The market will more than likely overreact again, as markets do, but it will certainly settle in to something well above today’s 1.30. Once again, Hecht has a forecast in mind: “Europe is playing a waiting game when it comes to Brexit, but time appears to be on their side. When a decision finally arrives, the Pound is likely to rally towards the $1.40 level against the dollar regardless of the outcome as the market is waiting for certainty in any form.”

And what about the U.S. Dollar?

The USD index has been trying to rally for months, especially after the Fed backed away from its hawkish stance on proposed interest rate adjustments for 2019. The upper band now sits at 2.50 percent. Four more hikes would have produced a 3.50 figure, which the Fed had presumed to be “normal” and from which it would have some slack in order to deal with the next economic downturn. Yes, we are late in the economic cycle, and a recession will come. The only issues are when and what will the Fed do about it.

Over the past six months, the greenback has surged into the high 97’s, only to pull back into range mode. It is trying hard to rally above 98, but there seems to be an “invisible hand” deliberately holding it back. All other major reserve currencies are weak at this time. There are no plans for normalization routines for the Yen, the Pound, or the Euro on the horizon, therefore maintaining the divergences that have persisted between them and the U.S. Dollar for some time. If trade negotiations show any signs of reaching a favorable conclusion, the Dollar can only go up. Economic growth may be slowing, but no other economy is picking up the baton and running with it.

Hecht’s forecast, once again, sounds like the voice of reason in a forest of wilderness: “Interest rate differentials favor a rally in the dollar, but the big hand at the US Treasury could be standing in the way of fundamentals by selling the dollar without abandon each time it reaches a level that would present a challenge to the technical resistance level. If stability and manipulation are synonymous at the US Treasury, this pattern could continue making UUP and UDN tools to capture the trading range.”

USD volatility implies that this might be the calm before the storm

The following chart comes by way of Bloomberg and JPMorgan, and according to these folks: “Currency traders should brace for a large move in the dollar.”

usd volatility

As the chart depicts, there have been three major slumps in the volatility index in the past 25 years, and each slump was followed by a major spike upwards in the U.S. Dollar index. Callum Thomas, founder and head of research at Topdown Charts, wrote: “We’ve seen this type of pattern show up a number of times before, and each time it did, it preceded a major move in the dollar. This is great for both U.S. dollar bulls and bears…the only people it won’t suit is those who expect the U.S. dollar to spend the rest of the year stuck in that tight trading range.”

Concluding Remarks

Are we about to see a major move in the U.S. Dollar? Data seems to support such a proposition, but we have observed quite a few remarkable charts in the past decade that claimed all sorts of dire consequences, based on previous data points, patterns, and behavior, only to witness each prediction go by the wayside.

Brexit has been postponed again, and low volatility could be with us until late October, and then, again, forex markets could erupt.

Be prepared!

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

Tom Cleveland
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