Sterling bounces as markets price in a softer Brexit

The huge margin of defeat suffered by Theresa May's withdrawal agreement paradoxically boosted the Pound last Tuesday, which finished the week atop the G10 rankings.

A string of weak economic data from China and the Eurozone was positive for the Dollar, where the government shutdown means little macroeconomic news is being released. Market focus this week switches to the European Central Bank (ECB) and, to a lesser extent, the Bank of Japan. Key to the former's January meeting is the extent to which recent economic weakness in the Eurozone is recognised by the Council. Chinese GDP data out on Monday will also be key to gauge the impact that the trade war is having so far.

GBP
The UK Government suffered the biggest electoral defeat in British history, as May's withdrawal agreement was rejected by 230 votes.

Markets reacted by lifting Sterling. The reasoning seems to be that a no-deal Brexit is a very low probability event, and the scale of the rejection means that the only deal that could conceivably get through Parliament is a considerably softer Brexit that could be partially supported by the Labour Party. We do not disagree with this assessment, and continue to think that there is additional room for Sterling appreciation in the coming months.

EUR
German economic growth for the entire 2018 was reported at 1.5%, which means that fourth-quarter growth was almost certainly positive, if just barely. Nevertheless, ECB President Mario Draghi acknowledged recent weakness. This sets up Thursday's ECB meeting to report a further downgrade in their economic assessment, which would essentially rule out any hikes in 2019 in our view.

Considering this negative news, it's impressive that the Euro has so far managed to defend the 1.13 level against the US Dollar.

USD
In part due to the Federal Government shutdown, only second-tier data were released last week in the US. This week looks much the same. Markets are therefore having to seek guidance from Federal Reserve communications, and these have turned clearly dovish in the New Year.

The abrupt change in tone here means that the Fed’s "dot plot" of future rate expectations released in the December meeting is effectively obsolete. Absent a spike in inflation, it is likely that we will see either one hike or none at all in 2019. This environment should prove very supportive of emerging market currencies in general, and most of them have rebounded quite strongly so far in 2019.

-Enrique Diaz Alvarez