We don’t see how GBP can maintain its strength. Too much uncertainty: GBP/USD is currently trading at 1.3112, approaching 1.3065 short-term. UK Prime Minister Theresa May says she’ll return to Brussels to convince the European Council to remove the Northern Ireland backstop. Yeah, right.
Parliament agreed with her not to rule out leaving the EU without a formal deal. Ironically, the agreement contains no clear guidelines as how to avoid a hard Brexit. At the same time, it limits May’s rhetoric that the House of Commons is causing a no-deal Brexit by not supporting its Withdrawal Agreement. Still, a few minutes after the Commons’ votes, European Council President Donald Tusk repeated that concessions on the existing divorce are impossible. This risk of no deal does not seem to stop GBP traders buying long positions.
The key question remains: why would UK MPs require May to go back to Brussels if the odds are clear? As the Council won’t accept any amendments, it will probably accept a conditional extension of the March deadline constrained by a second referendum or general elections, or it will force certain UK MPs to vote for remaining within the EU customs union. Time is running short to the mid-February deadline.
Inversion is coming
2019 started with a cautious outlook. Outside the US-China trade tensions, worries centred on the effect of the US Federal Reserve tightening. Normalization came when risk appetite was shaky and valuations for stocks and bond were elevated. Now markets have rebounded in reaction to dovish Fed comments of a “pause” in interest rate hikes. The shift in tone drove a steep rally. Volatility remains elevated yet risk appetite has continued.
There are plenty of reasons for investors to remain cautious in 2019. The best indicator of US economic recession is in the red zone. It’s likely that peak in 10-year Treasury bond yields for this hiking cycle was reached in October at 3.25%. At this duration, yields are likely to trade in a range of about 2.50% to 3.00% in H1 2019. The problem is the erosion of the US economic outlook. Inflation expectations have been grinding lower as fiscal stimulus fades and trade tensions increase. Markets expect inflation to remain near 2.00%. This suggests a gap of 80 basis points between expectations and 10-year-treasury yields. Inflation would need a massive surge in growth to push yields meaningfully higher. Yet the Fed has pushed up short-term interest rates when yields are falling. The spread between 3-month Treasury bill yields and 10-year Treasury bond yields has flattened significantly, suggesting eventual inversion. There is really concern that if the Fed proceeds to hike rates 25-50bp in 2019, the effect on short end will move higher than long-term rates.
