Oh, Flower of Scotland

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Leading up to the referendum on Scottish Independence, one trader remarked “there will be blood on the trading floor Friday” if the Scots were to vote “Yes” and chose to break the 307-year-old union with the United Kingdom. That’s because money was already flowing back into the assets classes that were negatively affected by the uncertainty surrounding Scottish Independence on the basis that a “No” vote would ensue. Evidently, exit polls were giving traders enough information to bet the outcome. The money illustrated the results in Thursday’s referendum as the pound gained approximately 2 per cent from its lows of the week before votes had even been tallied. However, what later resulted was a clear “buy the rumour, sell the news,” as the pound gave back most its gains Friday morning.

The theatrics associated with the unknown outcome definitely took a toll on markets as we head into the tail end of the third quarter. But the underlying theme or message is certainly an important one as an astonishing 45 per cent of the population voted for independence in a referendum that saw approximately 85 per cent of their population participate. The message for those invested in financial markets is that populism has the potential to trump pragmatism when it comes to governance and economics.

Any economist leading up to the vote rationally stood on the side for Scotland to remain a part of the UK. The greatest concern, and one that could only be discussed hypothetically thanks to a lack of detail from Alexander Salmond, leader of the Scottish National Party, was what currency to adopt. With over 9 per cent of Scottish GDP coming from their financial services sector, and part of the benefit being that the pound still serves an important role as an international currency, how would the banks react? Initially Scotland discussed the idea of keeping the pound, an approach known as ‘dollarization’ where the pound still serves as the nation’s currency, but monetary policy and facilities like deposit insurance are not conducted or utilized in Scottish interests. All of these measures that promote stability and longevity in a currency, and thus become a harbour for capital and commerce would be jeopardized.

Other obvious issues surrounded the idea of disruptions to business and a worsening Scottish deficit. Estimates had it that around 60 per cent of Scottish exports are destined for the other three countries in the United Kingdom. There lacked sufficient reasons other than a phoney idea of nationalism to put up a border only to disrupt trade flow and make moving goods harder for businesses. Oil reserves in the North Sea were perhaps the saving grace for Scots, but when transfer payments from Westminster equaled the royalties received from North Sea drilling this year, and projections for North Sea oil are vastly diminishing, financing their 7 per cent deficit looks like a challenge. This compares to EU nations, which outlined by the Maastricht treaty look to maintain a deficit-to-GDP of 3 per cent.

There is the angle that it was the Scots incentive to fear Westminster with an independence vote to benefit more from government or take back more autonomy over more local issues of their economy, and the latter outcome will likely prevail. But the takeaway for investors has got to be the potential for instability in nations were a misguided millennial-inspired movement can have such a significant impact.

Dominating Dollar

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The resounding story for the markets these last few weeks has been the unequivocal strength of the US dollar. The dollar closed higher Friday for the ninth straight week as it continues on its best run in 17 years. This has been the move in the dollar that many investment professionals were looking for as they anticipated the US Fed to end their Quantitative Easing program and begin to raise the Federal Funds rate, but the move in the dollar really did not come to fruition until the latter half of this year. That, however, is not the only story that has been supporting the strong dollar trade as a number of both domestic and international factors are weighing in on the foreign exchange markets.

The international story is based on the action of western central banks. As the US has passed their inflection point from making policy more to less accommodative, the question through the end of the summer has been what future measures will be taken by the European Central Bank and Bank of Japan? And unfortunately for the Bank of England, despite efforts by Governor Mark Carney to talk up the pound, a referendum on Scottish Independence on the 18th of this month has substantially weakened the pound translating to a stronger greenback.

On the domestic side it’s perhaps investor’s lax expectations that shifted this market. The San Francisco Fed put out a paper this week looking at how investors and futures markets were anticipating when the Fed might begin to tighten policy and at what pace versus what members of the Federal Open Market Committee (FOMC) were actually saying in their most recent June meeting. What the San Francisco Fed found was that the market and investors are behind the curve in anticipating when the Fed will begin to raise rates. This is inherent in an expectation that the accommodative policy will be around longer than the Fed currently plans on delivering.

This all leads into what will be a very important week for the markets. The FOMC meets Tuesday and Wednesday, and following that on Thursday Scotland votes. No question, volatility which has been vacant from currency markets for so long is finding its way back. Accommodative policy from the world’s most influential central bank had dampened volatility from the FX markets. As we’ve learnt, this had an effect of suppressing and stabilizing interest rates at record low levels. But as the Fed shifts back to a less discernible role in the markets, volatility in currencies will begin to rise.

The unknown going forward is what it means for the US dollar, and commodity prices, along with equities and the outlook for earnings of US companies, with a foreign income stream. The same questions holds true for most other financial markets. A stronger dollar provides headwinds and at this stage the dollar looks like it will continue to dominate.

Super Mario Shows His Hand

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Mario Draghi and the European Central Bank (ECB) shocked financial markets this week when they yet again revealed they were prepared to further combat a stagnating European economy. They announced they were lowering three key policy rates to their ‘lower bound’ and unveiled an unconventional QE style stimulus program to purchase non-financial private sector debt. Unfortunately, the implicit message delivered was that their policy options are becoming exhausted, and consequently further accommodative policy saw the euro fall over 2 cents on Thursday against the US dollar.

The trimming of the key policy rates is only somewhat significant as they have taken their deposit rate, the rate of interest charged to financial institutions, further into negative territory. Ideally, no financial institution is going to take a loss or pay the ECB interest to hold their cash overnight, and ultimately it’s a facility that will not be used. In theory, it’s to create the disincentive to deposit funds with the ECB, and instead incentivise them to make money available to the business sector.

The other key lending rate to focus on is the refinancing rate, which the ECB cut to 0.05 percent. This is similar to where the Federal Funds Rate in the US sits between 0 and 0.25 per cent, and at 1 per cent in Canada. And again, a marginal 10 basis point cut does not make a huge material difference to incentivize banks to now borrow more and make loans, but it almost acts as part of a last resort move for the ECB attempting to stave off a deflationary environment.

These further rate cuts seem like a last resort tool for the ECB in terms of utilizing their conventional policy tools, which clearly are not providing the incentives with the liquidity to spur economic activity in the respective economies. With powerhouses like Germany actually seeing GDP growth contract in the latest quarter, and Italy now entering a triple dip recession, this crisis still very much drags on in Europe. But the question is, as monetary policy sees a diminishing impact, can further accommodation prolong the structural reforms so desperately needed?

Mario Draghi said at his press conference that these measures will only work if they come with the structural reforms on the fiscal policy side, and that is left up to the individual European governments. But as the ECB looks to protect its mandate of price stability in the euro, similar to that of the US Fed, policies in the last week have entered the experimental phase as they begin their targeted bond purchases.

The biggest shortfall of monetary policy in Europe was that it was not filtering through to the businesses that hire workers and advance the economy. As was seen by continuously lowering policy rates, credit has largely remained unavailable to the small and medium size enterprises. The announcement of purchasing asset backed securities is the first step in how the ECB plans to combat this.

As Draghi dictated and the market reacted, this is a policy that ultimately weakens their currency, where on Thursday the euro reacted and fell to its lowest level since July of last year. Many are drawing comparisons to this and the Fed’s Quantitative Easing, or Abenomic’s and its three arrow approach in Japan. Moreover, the ECB is really the last major central bank to join the experimental policy party, and whether they will be successful is not the question, as six years into recovery, investors have learnt the hard lessons of not betting against central banks. Instead, what is the cost of experimental policy and ongoing government malaise?

A question we are still awaiting an answer to here in North America.