Political factors continue to drive the FX market

2024 was always going to be a big year on the political front given the large number of elections. Some of these were easy to predict in advance, like the UK election in July. But others have been harder, like Japan’s weekend election, while ‘the big one’ in the US on November 5th remains a toss-up according to the opinion polls. Winning the UK election in July was the easy part for the Labour Party; the hard part is governing.

This Wednesday’s budget represents the toughest challenge so far as Chancellor Reeves sells the argument that the government needs to raise revenues from taxpayers to fund higher public investment. If this is not a hard enough sell, financial market patience could be tested by the expected Gerrymandering of the debt calculation used for fiscal probity purposes to free up as much as GBP50bn for investment.

Given the way that a previous chancellor, Conservative Kwasi Kwarteng pushed market patience too far back in 2022, there may be concerns that Reeves could spark a similar meltdown in the pound. But we do not think that will happen and remain moderately bullish for the pound on a medium-term basis as we look for sterling/dollar to scale 1.40 and for euro/sterling to sink to around 0.80 over the next year, or two.

Perhaps one factor that might aid the pound this week is that the broader FX market is still staring rabbit-like into the advancing headlights of the US election juggernaut on November 5th. Opinion polls remain broadly tied at the national level although Republican candidate Trump seems to have the momentum such that betting markets already seem to have declared him the winner.

Of course, we can’t take this as a sure sign of a Trump victory, although we’d note that, back in the 2020 election, Trump and Biden were tied briefly in September of that year but, by the time of the election, Biden had soared to a lead of 63.8 to 35.4. That proved an accurate guide to the election outcome and, judging by the way that the dollar has been nudging higher recently it looks as if the FX market sees it as a good indicator as well.

We also see that post-election risk reversals in the options market are generally skewed in favour of dollar calls. Our view is that Trump will win and that this will push the dollar forward. The key in such an event will be whether euro/dollar can decisively break below the 1.05 level that has been the base of the 1.05-1.1275 trading range that’s been in place since late 2022. That’s a very long time for euro/dollar to be captured in such a small range. The question surrounding the election is whether euro/dollar has wound itself up in a spring-like fashion, such that the release of the tension, once the election outcome is known, could propel euro/dollar down to parity or below should Trump win.

“We have to say that we are sceptical that the euro will display such springlike qualities but, even if it does, we suspect that, like a spring, the euro will recover over time, not just to return to this trading range but to improve further against the dollar. The key here will be to what extent the Fed pushes on with rate cuts in the event of a Trump victory. We suspect that it will not waver significantly, and that should help prevent any large and sustainable dollar rally from developing over the longer-term”, said Steve Barrow, Head of Standard Bank G10 Strategy.

While euro/dollar has been incredibly stable in recent years, the yen has been very unstable, and the weekend election outcome in Japan threatens to maintain this dichotomy. The LDP’s failure to secure a majority for the first time since 2009 suggests that it will have to pull smaller parties into a coalition and a number of these are sceptical about the wisdom of recent Bank of Japan rate hikes. But could their entry into the government have a bearing on monetary policy?

“We very much doubt it. Instead, the BoJ is seen pushing ahead with rate hikes until it has reached levels in the vicinity of 1%. That might still leave the policy rate 2% points, or more, below US rates by the time the Fed has finished easing but we do think it will be sufficient to pull dollar/yen down over time. However, in the near-term, a victory for Trump next week does threaten a return to the highs of over 160,” stressed Steve Barrow.