Is Perfidious Albion undermining ‘Shanghai Agreement’?

Back in the early 1980s, foreign exchange volatility wreaked havoc on business spending plans and countries’ ability to repay foreign currency debt. To remedy this situation, the world’s key financial policymakers got together, first at the Plaza Hotel, New York in late 1985 and then in early 1987, in Paris to agree on a plan for coordinating monetary policies; the idea was to reduce currency volatility and so limit the scope for financial shocks. Unsurprisingly, global investors loved the idea that they would no longer get sucker-punched by large currency swings and as a result all risk assets ripped higher.

Gold and silver miners were especially big winners as silver prices more than doubled between the summers of 1986 and 1987. Deep cyclicals rallied hard, as did emerging markets (Hong Kong equities more than doubled in the period, while Taiwan (where 10% of adults were day-trading) started to redefine what a financial bubble looked like. These go-go years came to an abrupt halt after a rise in bond yields through the summer of 1987. In response, the Bundesbank (which back then was a genuine inflation hawk) panicked and in October 1987 raised short rates. US Treasury Secretary James Baker responded angrily: “We will not sit back in this country and watch surplus countries jack up their interest rates and squeeze growth worldwide on the expectation that the United States somehow will follow by raising its interest rates”. Hence, it was clear to all concerned that the Louvre Accord was dead and buried. The next day, the Dow Jones Industrials opened down -27%.

So, why re-hash ancient history? Because careful readers will have noticed that in recent months I have espoused the idea that, after a big rise in foreign exchange uncertainty— linked to fears of further yen, euro or renminbi devaluation— the big financial powers acted to calm markets following their February meeting in Shanghai by spreading the rumour that henceforth central banks would coordinate monetary policies and avoid imposing “shock and awe” on fragile financial markets. And sure enough, since then, almost every press conference following a central bank meeting has delivered yawn-fests of platitudes. In short, we have in recent months, been living under the calming influence of a “Shanghai Agreement” (such an agreement may or may not exist, but the fact that market participants believe it does has perhaps minimised the actual intervention required!). And, as in the post-Louvre Accord quarters, since February’s G20 meeting in Shanghai, emerging markets have started to outperform, as have deep cyclicals, gold and silver miners. It’s all felt wonderful, if not quite as care-free as the mid1980s.

As an emerging-market bull, I don’t want to look a gifthorse in the mouth. If a “deal” was done to ensure limited currency volatility, then the really big risk to emerging markets (namely, a US dollar spike) has been removed. If correct, this allows investors to focus on the superior growth profile of emerging markets, attractive valuations and falling real interest rates. But of course, this does not remove the nagging worry of “what if the Shanghai agreement comes to a brutal end as in 1987?” (back in 1987, the Hong Kong stock exchange closed for a week as it could not handle a tsunami of sell orders). And how could such an end come to pass at a time when no central bank is ever going to be as hawkish as the mid-1980s’ Buba?

Until his recent self-immolation, the most obvious threat to the Shanghai Agreement seemed to be a Donald Trump presidency. After all, here was a US presidential candidate who threatened, with his open protectionism and isolationism, the very equilibrium on which the post World War II economic order had been built. So with the odds of a Trump win melting faster than morals at a bachelor party, should we assume that the Shanghai Agreement lives on unthreatened, and pile on the risk? Perhaps not so fast, for in recent days, it “feels” as if foreign exchange volatility, after months in a coma, is coming back to life. And it may turn out that it is not Donald Trump who put the boot in to the lovely compromise reached in February, but instead Perfidious Albion. Let me explain:

When Britain voted for Brexit on June 23, sterling logically fell to one standard deviation undervalued against both the US dollar and the euro. Amazingly enough, the broader ramifications of this sudden shift were ignored by investors and, soon enough, global markets were rallying hard. But then, at the Tory Party conference two weeks back, Theresa May doubled down by promising to activate Article 50 by next March, and with it an irrevocable exit for the UK from the European Union.

Now, this March date was surely not a coincidence: by activating Brexit just before the French and German elections, Prime Minister May made sure that Brexit would become a big part of the campaigns unfolding in the eurozone’s two key economies, and more importantly, Britain’s two largest trading partners. In short, by choosing this date, Theresa May has enrolled the lobbying department of every major French and German automaker, machine-tool manufacturer, and even farmer, to the cause of negotiating a graceful exit for Britain. And, in case these various economic actors did not get the message, the second massive leg down in the pound in recent weeks should focus minds on Britain’s needs. To cut a long story short, with a euro at a generational low of 0.9 to the pound, will it be long before French farmers start to barricade the ports of Calais and Boulogne, and unload truckloads of manure in central Paris while complaining about underpriced British milk, beef, and sheep intestines (or whatever foul things people eat in northern parts of the UK)?

With the GBP collapsing, European policy-makers now be eager to do one of two things, namely:

will

1) Quickly surrender to Britain’s Brexit demands, in a bid to push the pound higher and avoid a world of trade pain.

After all, consider the lobbying power of different industries around the world. In the US, the strongest lobby, bigger even than the National Rifle Association, is that of the lawyers’ which ensure there can never be meaningful land tort reform. In Germany, the auto lobby dominates, which is why everyone can drive like a bat out of a hell on German highways. Meanwhile, in France, the most powerful lobby, by far, remains that of the farmers—farmers who, along with the German automakers, will not look kindly on the current exchange rate of the euro to the pound.

2) Devalue the euro, in a bid to cushion the effect of the pound’s collapse.

But if such a policy does now get embraced, the action surely spells the end of the Shanghai Agreement?

In recent days, it “feels” as if the markets sense this latter threat. Not only does the euro seem to be breaking down, but other countries’ currencies are also starting to feel wobbly. The renminbi is back to testing its lower limits. The Swedish krona has lately been weaker on no news at all. Despite higher oil prices, the loonie is back at CAD1.33 to the dollar. The Mexican peso has not celebrated, as one might have expected, the demise of the Trump campaign. Perhaps all of this will amount to nothing. But in the face of the recent pick-up in foreign exchange volatility, I would reiterate the point made a few weeks ago. A pick-up in forex volatility from here would very much be a “risk-off” development.