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British bond market exhibits 'a loss in confidence' following sterling declines: Strategist

TD Securities Global Head of FX Strategy Mark McCormick assesses the outlook of foreign markets amid volatility in the euro and British pound, regional trends, and global inflation concerns.

Video Transcript

- Well, big story of the day, the British pound falling to an all time low against the dollar in earlier trading, prompting speculation that the Bank of England may have to raise rates more aggressively to tamp down inflation. Let's bring in Mark McCormack, TD Securities Global Head of FX Strategy. Mark, it's good to see you. So we have a surging dollar, the pound plunging, euro at a 20-year low against the dollar. Just help us make sense of the moves that we're seeing in the FX market and what this means for retail investors.

MARK MCCORMICK: Right. So this is a function of global dynamics, global growth dynamics, which you just discussed. This is also about central bank policy, the inflation theme, and also terms of trade. What's happening in Europe is they are dealing with a massive terms of trade shock, which means the cost of imports are rising. They have no control over energy prices.

And so real rates, the rate the central bank has, nominal rates minus the level of expected inflation, are moving against European currencies, which is pushing them dramatically lower. If you think about Sterling, what we got is basically a fiscal package, which is there to design to support growth.

But it comes with basically no tax revenue build up. All of it's supposed to come through economic growth. There is no real challenge to how they're going to spend money. And so basically there's been a loss of confidence in the gilt market and Sterling. So that's why we've seen the collapse there.

- And for multinational companies who are watching this happen, what do they need to be keeping an eye on right now?

MARK MCCORMICK: Well, yeah, you have to think about how these three factors work together. We've got the global growth dynamics, which are quite important. You have to think about what's happening in China. Again, we still have the zero-COVID policy. We're on and off in terms of whether or not things can grow there. What we have is basically Asia and China, in general, trying to ease financial conditions. They're cutting rates. They're trying to stimulate growth. They are dealing with low inflation.

In the US, it's different. The US is dealing-- they're trying to tighten financial conditions. They are trying to raise rates. They're trying to take some steam out of markets in general. And in Europe, the financial condition shock has been imposed on them, again, by these forces related to the cost of energy and electricity and the terms of trade shock.

So I think what investors need to kind of keep their eyes on is really all the world's most important regions are divergent. And the way that the world kind of absorbs these shocks is through the currency market. And that's why there's so much volatility. This is why currencies are doing different things in different regions.

But the key thing in the very short term to keep your eye on is we have an inflation report coming up that's going be very critical. We had a very good inflation report. Then we had a very bad inflation report. And now we've seen again a pivot in the Fed's relative hawkishness, which kind of dovetails with what we've seen in the latest report.

But if we get an inflation report that's a little bit more benign than market expectations, we might see some pressure come off in the very short term. But again, for the next three to six months, we are still dealing with a challenging global growth environment. We're still dealing with persistence in terms of figuring out where central banks stop in terms of their terminal rates. And then lastly, again, this ongoing terms of trade shock is not going to dissipate through the winter, unless we get very lucky and have a warm winter in Europe.

- Mark, it doesn't seem like anything is stopping the dollar's momentum, at least right now. What's it going to take in order for us to see the dollar peak?

MARK MCCORMICK: Yeah, it goes back to the inflation in the very short term. We have these indicators. We call them stagflation indicators. What we're doing is looking at relative global inflation versus relative global growth expectations. The dollar is running about a 12% premium, which is pretty unheard of in a framework like that.

So if you kind of look at also the correlation of the 60-40 or the risk parity portfolio, the dollar is like the perfect stagflation hedge. You get a little bit of a yield. It's negatively correlated with equities. And so if you have a bearish view on equities and credit, the dollar is a great place to kind of sit there and wait things out.

So for things to change, we need to see inflation numbers. And again, I think what people are a little bit too focused on the core numbers because core is-- 40% of that is represented through the housing market, which again, the Fed has very little impact on the housing market in the very short term. But I think the things we want to continue to see is the downside in commodities, the slower move in producer prices.

Again, the fact that we're seeing supply chain indicator stress start to alleviate are good signs. But we need to see the next inflation report come in line expectations with markets. That will help cool things a bit. But for the full turn in the dollar, we're going to see need to see the global economy start to recover. So we'll need Chinese financial conditions to kick in. We need to see Europe kind of work through this terms of trade shock, which is going to, again, take us through the winter. And we have to see kind of global peak inflation. So those are the three factors.

- And Mark, not to put you on the spot, just when we're trying to gauge, I guess, where we're headed from here, six months from now, where do you see the dollar?

MARK MCCORMICK: So I'd say in six months, it's still relatively resilient. I'd say if you want to go 9 to 12 months, we have a very big drop expected in the dollar. I think one of the things that people have done through COVID, which has been very challenging, is you're kind of taking these peak extremes that have been pulled in through the pandemic itself and extrapolating.

If you extrapolate it from where we started with COVID, we would have never seen a recovery in the economy. We saw massive rebound in data surprises and data expectations through right after the economy started to reopen. We had a massive reflationary trade because of all the stimulus we got. Now we've seen the removal of the stimulus and some of the normalization.

So I think to extrapolate this world, the one we're in now, for the next 12 months, is going to be challenging. I think the next six months we still have the dollar generally resilient. But I think it's starting to turn over. And we're starting to forecast a lower dollar six months out. I think if you want to go 12 months, we do have the dollar falling by-- the levels of some of the risk premium that's embedded there-- by 12% to 14% against specific currency pairs.

- And Mark, I just want to quickly ask you about the new Italian prime minister, obviously, Italy, the third largest economy in Europe. What are you keeping an eye on there? And do you expect any shift as a result of this?

MARK MCCORMICK: No. It's very interesting. For the first time Italian politics has taken a back seat, and European currency moves to UK-based politics. I think, again, what people are going to be watching here is the BTB Bund spread. Is there a lot of pressure? It does seem like a lot of what we've seen from Italy has been a lot of rhetoric. And the rhetoric so far hasn't really matched anything in terms of policy seemed a little bit more tempered relative to expectations. The prime minister is kind of saying the right things.

So I think in this regard, Italy's kind of a secondary force. I don't think it's a big driver. I think we knew where we were going. So there's not too much that we're watching there. I think you're going to want to see some of the spots, who's going to be leading the finance ministry and some of these key appointments. But other than that, the market's just going to continue to monitor the BTB and Bund spread. But for this moment right now, euro Sterling and European currencies in general is really going to be dominated by what's happening in the UK, fiscal policy rather than European politics.