The big relief rally in markets that kicked off the week faded overnight with many markets pausing ahead of this week’s potentially big developments. Overnight the Nikkei rose 1.3% while in Europe this morning, the FTSE is flat and the Dax is up 0.4%. US indies futures are also up 0.4% while gold and WTI crude oil have dropped back 1.2%.  

 

The main event in the US today is FOMC Chair Yellen’s testimony to congress. Fed watchers and trades will be looking for signs on when she thinks the Fed may need to raise interest rates again and how the US economy is doing. In particular she needs to reconcile contradictory forecasts about the US economy.

 

On the one hand, we have St. Louis Fed President Bullard who recently switched from being a hawk calling for 2 rate hikes this year to an ultra-dove calling for one rate hike between now and the end of 2018. He also cut his US GDP forecast despite signs of accelerating consumer spending in the US and elsewhere. These actions suggest he thinks the US is going to struggle for a long time to come and perhaps fall back into recession.  

 

On the other hand, homebuilder Lennar posted earnings and sales way above street expectations today and it’s CEO noted the following: “The homebuilding market continued its slow and steady recovery sustained by low interest rates, modest wage growth, positive consumer confidence and low unemployment levels combined with tight inventory levels." Recall that a slowdown in housing and construction caused the last recession. These statements suggest an expanding economy from people who are tied into consumer spending and should know.

 

In the afternoon, FOMC Governor Jerome Powell a permanent voter who doesn’t speak very often is out taking which may also attract some interest from traders.

 

 

The Brexit debate has been the talk of the town again overnight. Polls were split indicating a very close race. YouGov Times released its second poll conducted since Thursday showing that after an initial swing to Remain Thursday and Friday which gave Remain a 44%-43% lead in their last poll sentiment over the weekend started to move back toward Leave giving them a 44%-42% lead. An ORB/Telegraph poll but Remain ahead 53%-46%.   

 

The big news was comments from financier George Soros, who became famous as the man who became a billionaire beating the Bank of England back in 1992. That time, he achieved success by going against the crowd, this time, however, he has joined the Chorus of Brexit Doom, forecasting a 15%-20% drop in the pound should Britons vote for Brexit. Such an event in my opinion is extremely unlikely and if it did happen would not last very long. Here’s why.

 

First of all, the Brexit vote has been coming for a long time and has been generating a lot of public interest and media coverage. This is not a surprise event. Traders have had lots of time to formulate opinions, strategies and contingency forecasts for the results. It would require a major surprise to drive a move of the magnitude Soros is calling for.

 

Second, trading in the markets over the last six months indicates that the prospects of a Brexit have already been priced in. For the most part GBPUSD has been trading between $1.4000 and $1.4800. Last week, when Leave had all the momentum, Cable was trading at the low end of this range. The sudden surprise swing in momentum toward Remain sent GBPUSD back to the high end of this range. The speed and strength of the turnaround indicates that near $1.4000 the prospects of a Leave win had already been pretty much priced in.

 

Suppose Soros was right this time what would a 15-20% drop mean? The first 5.4% of that would take the pound back to $1.4000 where it was trading last week and a 6.4% drop would take GBPUSD back to the February low when Cameron’s deal was announced. A 15% drop would take the pair back to $1.2580 and a 20% drop from recent levels is around $1.1840.

 

What the people issuing dire warnings tend forget is that markets and economies are interconnected, very few countries operate in isolation or in a vacuum. A huge devaluation of Sterling would have major effects that would provoke responses within the markets and also force other parties to take action.  

 

A big devaluation of the pound would immediately make UK businesses much more competitive relative to their counterparts in Europe and elsewhere cushioning any blow from uncertainty while the UK negotiates new trade relationships with Europe and other partners. It also would make the UK a much cheaper travel and tourism destination.  

 

A devaluation in the pound would likely attract capital to the UK. Many of the companies in the FTSE 100 are among the world’s largest multinationals. Putting big oil, miners, banks and insurers among others on sale by 15-20% would attract interest from investors and drive the FTSE up just like the Nikkei rises when the value of the Yen falls. Similarly a big drop in the pound would make UK real estate suddenly cheaper to foreign purchasers.

 

A big currency devaluation would act like monetary stimulus, so the Bank of England would not need to cut rates. It could cause an increase in inflation which would keep the bank neutral of perhaps finally force Governor Carney to do something like raise interest rates for the first time since he arrived in England.

 

Currencies trade in pairs, when one goes down another goes up which would also have big implications. A GBP crash would likely send EUR sharply higher and spark flows of capital into defensive havens like JPY, CHF and gold. This would make the Eurozone much less competitive relative to the UK and export deflation to the Eurozone and Japan undermining their QE stimulus programs.

 

Because of the potential negative effects, The Bank of Japan and the Japanese government have been indicating quite forcefully in the last few days that they are prepared to intervene in the market to stabilize JPY in a Brexit volatility scenario. The ECB has also indicated plans to intervene albeit more quietly along with the Swiss National Bank. Just this morning, Sweden’s Riksbank indicated it has plans in place and is ready for a Brexit.  

 

The Bank of England has been surprisingly silent on the matter of intervention, with Governor Carney apparently more focused on dwelling on the risks and uncertainties rather than indicating how the Bank of England would deal with different scenarios. A balanced approach would be to express concern about the risks of a Brexit but also to shore up confidence by indicating that the Bank stands ready to do its job and intervene as necessary to stabilize the currency and economy like other central bankers have for their own people.

 

Governor Carney seems to keep forgetting the latter part and appears to be more interested in trying to influence the will of the British people under the disguise of neutrality rather than respecting the will of the people he serves and preparing to support whatever decision they make. What could the bank of England do? There has been talk of the central bank stabilizing UK banks against a run on capital but also they could intervene directly in currency markets and may have to raise interest. The Bank of England doesn’t have to do all of the heavy lifting either, it could work in tandem with other central banks as they did during the 2008 financial crisis.

 

The high focus on the Brexit vote, the close race and the potential for intervention by central banks in addition to the market’s self-correcting mechanisms suggests to me that we may see significant volatility and trading opportunities. Discussions of worst case scenarios like the one proposed by George Soros, gives people a change to prepare for a big storm giving people a chance to prepare and making it less likely a big crash may happen.

 

 

Corporate News

 

Lennar $0.95 vs street $0.87 revenues $2.75B above street $2.60B

 

 

Economic News

 

Significant announcements released overnight include:

 

There have been no major economic announcements overnight

 

Upcoming significant economic announcements include:

 

(Note: 11:30 am in Sydney/Melbourne is currently 1:30 pm in Auckland, 4:30 pm in Vancouver, 7:30 pm in Toronto/Montréal, 12:30 am in London and 8:30 am in Singapore) 

 

10:00 am EDT               FOMC Yellen semiannual testimony to Senate Banking Committee

 

2:30 pm EDT                 FOMC Powell speaking