The fireworks are only just beginning

A couple of weeks ago I travelled north to Shropshire, to visit my girlfriend’s family for both some belated birthday celebrations and the local firework display. We’d liked to have enjoyed the Oswestry Borderland Rotary Club’s full event, which for avoidance of any doubt refers to the fireworks rather than my birthday, but in the interest of the family dog with chronic firework-o-phobia we had planned to enjoy the fireworks and little else before heading back home to accompany him. We’d perfectly scheduled consecutive pick-ups of Chinese and pizza takeaways, for an evening that was due to run like clockwork. But the pyrotechnics were nowhere to be seen. We were left confused for some time, and the food left going cold on the takeaway countertops. When they eventually came though, they were spectacular.

I’m aware this is a seriously tenuous segue. But who’d have thought that the Oswestry Fireworks Display would be a foreboding sign for what was set to be the busiest week in financial markets this year?

To recap, since midday on Wednesday 30 October we've seen the first Budget under the UK's new Labour government, where wealth taxes weren't raised so high as to force high-net-worth individuals abroad, but also failed to convince global markets that it was the makings of a sustainable solution for the UK's public finances.

We've seen the lowest non-farm payrolls print since December 2020, with the US economy adding just 12,000 jobs in October, albeit due to the effects from hurricanes Helene & Milton and staff strikes at Boeing.

We've seen Donald Trump re-elected as US President, and the Republicans win both the Senate and the House of Representatives, paving the way for some potentially quite extreme policy reform.

We've seen a second 25 basis point (bp) interest rate cut from the Bank of England, which forecasts that UK inflation will likely be 0.5 percentage points higher at the peak than it would've been in the absence of Chancellor Rachel Reeves's Budget, sparking jumps higher in gilt yields.

And we've seen the Federal Reserve follow up its 50bp cut with a 25bp reduction, where the subsequent press conference saw Chair Jerome Powell face an arguably bizarre barrage of questions on whether he'd resign following Trump's re-election.

In short, there's been a lot to digest, and FX markets had anticipated the risk accordingly, with some implied volatility metrics spiking to post-2022 highs in GBPUSD.

But the dollar’s rally post-election took some time to get going, and it seems the fireworks in FX are only just starting.

There are many reasons for that volatility to have stalled initially. First, the market will still be digesting the US election result. Perhaps some investors are sceptical on whether Trump will actually go through with his more extreme policies, and are waiting to see how his cabinet appointments shape up before inauguration day.

Perhaps some investors are sceptical on whether Trump will actually go through with his more extreme policies, and are waiting to see how his cabinet appointments shape up before inauguration day.

To some extent the implied volatility might not have been a fair reflection of expected volatility and was more a function of participants purchasing protection before the event. And lastly, maybe a Trump win had been more priced in than we thought. The USD had gained in October, sure, but not to the extent that you’d think a Republican clean sweep would imply. So maybe the market had been pricing in Trump 2.0 for a while longer than we realised.

Recall four months ago, when the Labour Party was just elected. The UK’s political situation looked more stable than it had for some time, meanwhile European politics had polarised. The UK economy was consistently outperforming expectations, such that interest rate differentials widened with UK rates higher. Generally, you would have judged that the sterling outlook was pretty positive. Arguably more positive than it was three and a half years ago, say, when GBPUSD was north of 1.4000. There are many reasons why we haven’t traded anywhere near those levels, but perhaps one of them is that there were already expectations of a Trump return.

Still, it feels like there’s more movement to come, even if the USD continues to strengthen as I type. Our own economists, along with others in the market, expect the USD to gain ground over the coming months, as more details emerge on Trump’s next term, such as his plan to appoint Robert Lighthizer as the US Trade Representative. Lighthizer held the post back in 2019 when the Sino-US trade tensions were at their peak. So, how Trump’s policies take shape over the coming months, quarters, and years will depend heavily on his final cabinet.

Couple that with a UK government trying to sort out its public finances; Germany calling a snap election for February; a global monetary policy cycle of rate cuts and questions over where rates will eventually settle; a Chinese economy still awaiting sufficient measures to solve its property sector woes; and geopolitical tensions remaining in both eastern Europe and the Middle-East, both with key implications for commodity markets.

What I’m trying to say is, there are plenty of risks ahead – I think we’re going to see the word ‘uncertainty’ cropping up an awful lot again. It looks like the fireworks may only be getting started.