Don’t make investment decisions on “likely outcome of elections”

01 May 2017

  • It’s all about fundamentals; don’t focus solely on “likely outcome of elections”
  • The European Central Bank and Bank of England remain dovish
  • Euro and sterling enjoyed an early spring, but May is likely to be less favourable

Sterling and the euro were the best performing Group of Ten (G10) currencies in April. Sterling rallied after the announcement from Prime Minister, Theresa May, of a snap general election on June 8 and the euro benefited after the results of the first round of the French presidential election on April 23.

The market believed that a larger government majority should reduce Brexit-related downside risks for sterling. The prospect of a strong conservative victory and a large government majority at the forthcoming election benefited the British pound. The idea is that Prime Minister May would be in a stronger position to make necessary compromises with the European Union.

The results of the first round of the French presidential election benefited the euro. Two of the four candidates who had a plausible chance of making it through to the second round, Le Pen and Jean-Luc Mélenchon, were both perceived in favor of France leaving the Eurozone. Emmanuel Macron made it to the second round and polls give him a significant lead over Le Pen for the second round.

We believe that the market reaction over the last weeks creates an opportunity to establish short sterling and euro positions. Politics will cease to be the only dominant driver of sterling and of the euro and fundamentals which are far from bullish will matter more. Both currencies continue to suffer from dovish central banks.

In the case for the Bank of England, the market is currently not penciling in a hike until the end of 2019. Based on two year rate differentials, GBP/USD therefore already looks very expensive at 1.29 and should drift down to around 1.15 next year if the forwards are realized. Importantly, the external balance of the United Kingdom remains weak. Despite upward revisions to the current account, the deficit remains above sustainable levels. A weak currency would help.

In the case of the European Central Bank (ECB), President Mario Draghi continues to stay dovish and reasserted the sequencing on exit. Our expectations remain unchanged after the ECB meeting on April 25. We expect forward guidance to be adjusted in June, tapering to be pre-announced in September and a one-off deposit rate hike in December. Importantly, President Draghi was pretty dismissive when asked whether Emmanuel Macron winning the French presidential election would have an impact on monetary policy, arguing that the council doesn’t ‘do monetary policy on the likely outcome of election’. We agree. The surge in sterling and euro based on “likely outcome of elections” are likely to reverse in May.

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