It’s Sink or Swim for Sterling

This morning, European equities are on the back foot, taking their lead from the slide in Asia and North America in the overnight sessions. European bourses are on the verge of forgoing all recent gains earned after the European Central Bank (ECB) President Mario Draghi’s surprise rate cut last week. Not helping investors’ risk appetite is the surge in Scottish independence support a week before Scots go to the polls, coupled with a new round of European sanctions against Russia that could be implemented. European leaders continue to weigh the progress of negotiations between Russia and Ukraine for the time being. Though Ukraine indicted that 70% of Russian and pro-Russian separatists have left their region, there are reasons aplenty to keep investors on the edge.

Pound under Pressure

With the professed intentions of Scottish voters narrowing a mere eight days before the referendum, both sterling and the U.K.’s FTSE 100 are under pressure. The index is probably the most “global” of equity indexes in the world (50% of company profits are offshore) and one would expect FTSE to rise as GBP falls. Currently, they seem to be trading in tandem, which would suggest that most U.K. assets are facing a risk premium problem. A “yes” vote could lead to a U.K. snap election and a close “no” vote will ensure the issue will not go away. Market consensus believes that GBP has probably fallen a bit too fast (£1.6100). It’s trying desperately to edge away from its 10-month low (£1.6065), but currently it’s looking like a “dead cat bounce.” The pound received some support from better-than-expected U.K. industrial production data yesterday (+0.5% versus +0.2%), combined with the Bank of England (BoE) Governor Mark Carney indicating that interest rates are likely to rise next spring. Nevertheless, the pound’s upswing is seen by many to be temporary. The “too far, too fast rule” will only allow those individuals who missed the boat to get on, and those miserably offside positions to mitigate their losses. Until there is some certainty surrounding Scotland’s future, sterling will remain at the mercy of capital markets.

During Canada’s Quebec crisis, it took some time for the loonie (CAD) to find rock bottom (USD/CAD $1.4243 01/19/95), and even longer to find its fair value well after political clarity was achieved. Sharp swings will be the order of the day in the U.K. markets. Two-week volatility in GBP/USD (14-day expectations) is trading around +12.6%, up from +6% just one week ago. Prices for sterling remain relatively wide and sometimes rather illiquid — like trading in a vacuum. No matter the outcome, either yes or no, volatility provides opportunity, but trading discipline is of the utmost importance during conditions like these.

Scotland Has Never Been so Important: Below is a list of the Scottish polls timetables that remain. If nothing else, the market should be expecting much price volatility around these releases.

France Fudges Forecasts

Europe’s second-largest economy lowered its growth forecast again earlier this morning, and France warned that the country requires more time to bring its public deficit back in line with European Union (E.U.) rules. The economy would grow +0.4% in 2014 compared with +0.5% forecast only a few weeks ago and by +1% next year, down from a +1.7% projection. The public deficit is expected to be around +4.4% of gross domestic product rather than the +3.8% expected. Further spending cuts tabled for next year hopefully will push this down to +4.2% and then below +3% in 2017. This is further proof that President François Hollande and company are fighting an uphill battle with the country’s low inflation and lack of economic growth (stagnation). It’s no wonder that France has been the most vocal on the EUR’s value — a weaker currency would obviously help.

Multiple Reasons for the EUR’s Support

The single unit seems to be well supported close to its yearly lows (€1.2945), despite all of Draghi’s efforts from last week. There is again upward pressure from EUR/GBP (€0.8040) that has emerged on the back of a suspect Scottish sovereignty vote. Also aiding the EUR is the current unwinding of EUR-funded carry trades that has been driven by the equity market, rising U.S. yields (next week the market is looking for a less dovish Federal Reserve), and surging option volumes. One could also throw in the reduced tension between Russia and the Ukraine as providing EUR support. Nevertheless, the EUR’s immediate upturn has yet to break any significant resistance levels on the topside (€1.3000 for starters). This would suggest that the market does not want to be caught offside by being too “long” EURs at the bottom as investors continue to focus on the E.U.-U.S. rate spreads for currency direction. Current market consensus believes in selling EURs on rallies until proven wrong.

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