The recovery in US yields continues to support the dollar as investors continue to feel a possible increase in inflationary pressures/expectations in response to the most likely increase in fiscal stimulus under a Democratic White House.
Meanwhile, the pound continues to strengthen in mixed markets today. British Prime Minister Boris Johnson told parliament that the restrictive measures are already “beginning to operate in many parts of the country.” The Canadian dollar is the second strongest today, climbing slightly due to accelerated growth in oil prices.
The third-largest dollar is cutting some of yesterday’s losses. On the other hand, the selling focus is returning to the euro again, and the Aussie and Kiwi also weakened slightly.
In December, the US CPI rose 0.4% mom, while the core consumer price index rose 0.1% mom. Both met expectations. On an annualized basis, the CPI accelerated to 1.4% YoY versus 1.2% YoY, which is above expectations of 1.3% YoY The core CPI remained unchanged at 1.6% y/y, which is in line with expectations.
A free trade agreement between the UK and the EU is welcome as it avoided a hard Brexit for trade in goods. However, trade tensions have intensified and the government has yet to clarify its post-EU industrial strategy, which should focus on productivity.
Aside from the relief rally, the free trade agreement provides no compelling reason to buy the pound now. “Against the dollar, the pound sterling is still 10% below its pre-2016 referendum level. Using OECD producer prices, it is estimated to be 8.5% undervalued compared to the US dollar. We believe the fair value discount is justified given the pressing economic challenges.”
Politically, a depreciated exchange rate is useful in the short term, as it helps maintain favorable financial conditions as the economy grapples with the COVID-19 crisis.
Low inflation and a large output gap caused by the pandemic mean that the likelihood of negative interest rates in the future is real.
Financing large budget deficits at negative interest rates may require a depreciation of the pound sterling to offset the UK’s risk to foreign investors.
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