GBP AUD - FUNDAMENTAL DRIVERS

2 May 2022GBP

FUNDAMENTAL BIAS: NEUTRAL

1. Monetary Policy

In March the BoE hiked rates by 25bsp as expected but delivered a bearish hike with BoE’s Cunliffe dissenting by voting to leave rates unchanged. This was a stark change from February where 4 members voted for a 50bsp hike. Cunliffe noted the negative impacts of higher commodity prices on real household incomes and economic activity as the main reason for his dissention, while remaining members thought a 25bsp hike was appropriate given the tight labour market and risks of second round effects. Even though inflation forecasts were upgraded to 8% in Q2 (previous 7.25%), the negative view that GDP was expected to slow to subdued rates showed growing concern of stagflation. The most bearish element of the statement was a change in language regarding incoming rates where the bank said they judge that some further modest tightening MIGHT be appropriate where previous guidance said more tightening was ‘LIKELY TO BE’ appropriate (a clear push against overly aggressive rate expectations). They further pushed back by noting the current implied rate path would see inflation would be below target in 3 years’ time, in other words saying they won’t hike as much, and confirms our estimates that policy reached peak hawkishness in February. The 100% odds of a 25bsp in May drifted to just above 80% on Friday, and markets will pay close attention to incoming BoE speak, where further push back against rates could be enough to see markets pricing out some of the >5 hikes still priced for 2022. As a result of the clear dovish tilt, we have adjusted our assessment of the bank’s policy stance to NEUTRAL.

2. Economic & Health Developments

With inflation the main reason for the BoE’s recent rate hikes, there is a concern that the UK economy faces stagflation risk, as price pressures stay sticky while growth decelerates. That also means that current market expectations for rates continues to look too aggressive even after the BoE’s recent push back. This means downside risks for GBP if growth data push lower and/or the BoE continue to push their recent dovish tone.

3. Political Developments

Political uncertainty is usually GBP negative, so the PM’s future remains a risk. If distrust grows question remains on whether a no-confidence vote can happen (if so, short-term downside is likely), and whether he can survive the vote (a win should be GBP positive and a loss GBP negative). The Northern Ireland protocol remains a focus, with previous UK threats to trigger Article 16 and EU threats to terminate the Brexit deal if they do. Markets have rightly ignored this as posturing, but any actual escalation can see sharp GBP downside.

4. CFTC Analysis

Very bearish signal from all three participant categories with the aggregate positioning (non-commercials, leveraged funds and asset managers) pushing below 1 standard dev from the 15-year mean. It’s important to note that this sentiment was clearly reflected given the big drop in Sterling this week.

5. The Week Ahead

For Sterling in the week ahead it’ll be all eyes on the upcoming Bank of England meeting. Recall at the last meeting that we saw quite a dramatic change in sentiment among the MPC with only 8 voting for a hike and 1 dissenter voting to leave rates unchanged. This was a big change from the meeting before that where all 9 voted for a hike and 4 voted for a 50bsp hike. A 25bsp hike is fully priced in for the May meeting (as well as an additional 5 by year end after that), so markets will be keenly watching the vote split to get a clue whether the overall sentiment for hikes among MPC members are changing (will anyone join Cunliffe to dissent this time). There are reasons to believe that more MPC members could be leaning to the dovish side as recent growth data has deteriorated much more and faster than expected. Especially with recent commentary from Gov Bailey cautioning that they are walking on a tightrope between trying to fight high inflation whilst trying to avoid a recession. That means with a 25bsp hike 100% priced, the focus will be on any signals the bank provides with regard to the rate path going forward (whether they push back against the overly aggressive hike expectations or not). The balance sheet will also be in focus as the bank’s has previously suggested that they will look to actively start selling Gilts once the cash rate reaches 1.0%. By following through with a 25bsp hike next week will put them at 1.0% so any announcement of sales or of a path forward will be important.


AUD

FUNDAMENTAL BIAS: BULLISH

1. Monetary Policy

At their April meeting, the RBA took a slightly more hawkish stance by removing their reference to ‘patience’ in terms of policy tightening. With the bank taking a sanguine view of rising price pressures, the statement did reveal a growing concern for inflation with 10 references to ‘inflation’ in the statement. The bank explained that higher energy and commodity price could see a sizeable increase to inflation forecasts in the May report. In their Financial Stability report the bank urged borrowers to prepare for an increase in rates, which was a further signal from the bank. Even though the meeting showed a bank that is turning the page, the statement also revealed very similar conditionality such as incoming wage and inflation data. Following the meeting, markets have a bit of an overreaction by pricing in a >80% chance of a rate hike at the May meeting but was later pushed back to <30%. Given the importance of wage data, and since that is only release on the 18th of May, the most likely meeting for a first hike is the June meeting. Westpac investment bank agrees with our take with the bank expecting a 15bsp lift off in June, followed by 25bsp hikes in July, August, Oct and Nov. Even though this confirms our fundamental bullish bias, the >14 hikes priced by end 2023 means risks of lower repricing is building.

2. Idiosyncratic Drivers & Intermarket Analysis

Apart from the RBA, there are 3 drivers we’re watching for the med-term outlook: Recovery – unlike other nations where growth & inflation is expected to slow, Australia is expected to see recovery, mostly thanks to stimulus in China China – With the PBoC & CCP stepping up monetary and fiscal stimulus, any recovery in China bodes well for Australia (China accounts for 40% of Australian exports). It also means the current virus situation in China posesshort-term downside risks for AUD. The AUKUS defence pact could see retaliation against Aussie goods and is worth keeping on the radar as well Commodities – Iron Ore (31%), Coal (14%) and LNG
(10%) is more than 50% of Aussie exports, with rising prices giving the AUD huge support from terms of trade. If commodities remain supported it remains a support for AUD, but of course also means any sizeable corrections would weigh on the AUD, which means geopolitical and China demand developments remain focus points.

3. Global Risk Outlook

As a high-beta currency, the AUD usually benefits from overall positive risk sentiment as well as environments that benefit pro-cyclical assets. Thus, both short-term (immediate) and med-term (underlying) risk sentiment will always be a key consideration for the AUD.

4. CFTC Analysis

Quite strange positioning change for the AUD with Leverage Funds trimming net-shorts by a chunky amount but Asset Managers showing a whopping build up in net-short contracts. The shift in Asset Manager positioning could explain the reluctance of the AUD to make any real progress despite very positive China developments.

5. The Week Ahead

The focus in the week ahead will turn to the upcoming RBA policy decision, as well as China developments and commodities . For the RBA, markets are pricing in an 85% chance of a 25bsp hike at next week’s meeting after the Q1 CPI saw all three inflation measures push above the bank’s target range between 2%-3%. With CPI reaching its highest levels in two decades one can understand the reaction in STIR markets, with some participants calling for the possibility of a 15bsp, 25bsp and some even look for a 40bsp hike next week. We think there is a higher probability that the bank chooses to wait until they receive the next quarterly wage price index on the 18th of May. There is also political optics which might see them stay patient as the Federal Election takes place on the 21st of May (and no politician would want to have rates hiked for the first time in quite a while three weeks before people head to the polls). Thus, with all of that in mind we think the bank will want to stay patient, which could open up some downside risk for the AUD in the short-term. However, if they decide to come out guns blazing with a 40bsp hike that could provide a catalyst to get back into AUDCAD longs. On the China side, all eyes will be on further stimulus promises and efforts from the CCP or PBoC (which should be supportive for the AUD, even though this past week it hasn’t been enough to support the Antipode). Furthermore, the classic risk sentiment correlation has come back with a vengeance these past two weeks, which means overall risk sentiment and equity price action might be taking back the limelight from commodities .