Brexit, Mexico, FX: What's Next?

MidWeek Bond Update

Brexit, Mexico, FX: What's Next?

Recent moves by the U.S. have encouraged talk of an end to the post-1945 world order in commerce and diplomacy. But business leaders and financial markets have reacted with relative calm, suggesting that the current chatter could be overdone.


That dynamic was clearly in evidence in the European Union this week. German factory orders in May 2018, released this past week, came in 4.4% above last May’s figure. But the widely-followed ZEW survey index of business sentiment in Germany came in at -24.7, well below the median forecast – and itself fairly pessimistic.[1]


Germany Factory Orders and Business Sentiment, July 2015 - July 2018

Source: Bloomberg, July 8, 2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Of course, it’s possible actual economic activity in June will follow the sentiment downward. And the U.S. re-escalation of trade tension this week (via the threat of $200 billion worth of additional China tariffs) isn’t likely to bring cheer to Germany’s business community. But given China’s active solicitation of business within the EU since the outbreak of trade tensions this year, any tariff-driven pullback could conceivably be more than made up for in new orders from new sources.
 

On the Rise: Mexican Peso, Post-Election

Before the July 1 election, Mexican candidate Andrés Manuel López Obrador (AMLO) was revered as a reformer, but feared as a firebrand. But after winning the Presidency with over 53% of the popular vote, both he and his party have taken pains to state that they bear no hostility toward the private sector, and will concentrate on investment as well as social support.  Their plans are expansive, as well as potentially expensive, including reinvestment in the energy sector as well as increasing support to lower-income people and retirees.

So far, markets have taken AMLO at his word. After a one-day pause, the Mexican peso has appreciated solidly, rising more than 1 percent on three out of the eight trading days since the election – including one record-breaking rise of over 2.5%.


U.S. Dollars per Mexican Peso: Price and Daily Change (%)

Source: Bloomberg, July 8, 2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Because the newly-elected government won’t take power until the end of 2018, there’s still time for the rhetoric to shift. But the current moderate tone of his statements is being greeted with relief, at least for the time being.

 

On the Slide: British Pound FX Volatility

After the departure of “hard Brexit” advocates David Davis and Boris Johnson, PM Theresa May’s government faces new political pressures.  Yet even if it survives, the likelihood of its softer negotiating stance surviving negotiations with the European Union (EU) appears limited. Europe’s chief negotiator for Brexit, Michel Barnier, has suggested in previous statements that easing the way for a member state to leave the European Union wasn’t in the EU’s interest. And given the lack of consensus about how to approach Ireland’s border with the UK, the likelihood for continued disarray appears strong.


Exchange Rate Implied Volatility, British Pound vs. U.S. Dollar

Source: Bloomberg, July 8, 2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


So it’s all the more surprising that implied exchange-rate volatility for the pound continued to fall, both for the near-term and for one year out. One possible explanation: Brexit is an evolving economic story rather than a specific time-bound event; the negotiations have so many deadlines that the markets aren’t yet differentiating between so-called “drop-dead” dates with direct financial impact and milestones with more diffuse economic impacts.

Another possible explanation: markets are waiting until there’s some tangible news that has direct supply-demand impact on the global flow of capital.  

 


All data Source: Bloomberg, on their respective dates unless otherwise specified.

[1] The ZEW (Zentrum fuer Europaeische Wirtschaftsforschung) Survey indicator is a diffusion index, with numbers below zero representing negative sentiment, and numbers greater than zero representing optimism.

 

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