Political developments trump fundamentals for dollar, pound

One interesting theme for the second half of 2016 as well as for the first few days of 2017 has been how political developments are moving two of the world’s most important currencies: the dollar and the pound. The two currencies are paying less attention to economic fundamentals and more on the pronouncements of the two countries’ new leaders, Prime Minister Theresa May and President-elect Donald Trump on Brexit and possible fiscal stimulus respectively.

In the UK, statements by May earlier this week indicated that the country would prioritize control over immigration during its upcoming negotiations about leaving the European Union. This had a profoundly negative effect on sterling, despite some recent positive UK economic news such as upbeat business activity surveys across manufacturing, services and construction as well as higher-than-expected industrial output. The single-minded focus of sterling traders on what kind of Brexit will be negotiated contrasts with the broadly optimistic view of UK business, as demonstrated in the improving PMI readings. This divergence could lead to even more volatility in the future and one group – UK business or forex traders – should be quite surprised by future events. For now it appears that a ‘harder’ Brexit will have a more negative impact on the UK economy than anticipated but this is not preventing UK businesses feeling optimistic about the future. Brexit developments will probably continue to overrule economic news – that is until negotiations between the EU and the UK start and expectations start forming about the kind of deal that will take shape.

In the United States, the ‘Trump’ dollar rally as a result of expectations of fiscal stimulus and faster growth after the President-elect takes office, has been a key theme for currency markets. This week the press conference of Donald Trump seemed to disappoint investors that expected more details on upcoming economic policies. During the dollar rally there have also been some upbeat economic news, but the data has not been enough to justify a substantial change in the economic outlook for the United States for next year. The Federal Reserve also seems to be more optimistic with respect to next year, but its economic forecasts have not really changed to reflect such optimism. The Fed has also been trying to dissuade the implementation of any big fiscal stimulus plans on the grounds that the economy is already near full employment. To be fair, the dollar was in an uptrend before Trump’s election to the US presidency but the dollar’s gains really accelerated after Trump’s victory.

To sum up, during the past few months, both the US dollar and the British pound have made some really significant moves based mainly on political developments that were much less dependent on actual economic data. Interestingly, both the rally in the US dollar and the plunge in the value of the pound, do not reflect imminent changes in the economic outlook but rather the market’s best estimate of where a set of new and unclear policies will land the two economies in the future. Because of their nature, such estimates can be very subjective and lead to substantial future volatility as market participants will need to adjust their positions on the basis of incoming information that can appear erratic and contradictory at times.