GBP weakness just beginning

There is certainly some risk premium in GBP related to concerns about Brexit, but it’s hard to see why this will disappear. Given that the market is still betting on a 65-70% chance that the referendum will produce a vote to stay,  based on the betting exchanges, it is hard to see the risk premium even diminishing much in the run up to the vote. If the Scottish referendum vote is anything to go by, the full risks may not be priced until quite close to the poll, which is now set for June 23. Of course, there is some GBP weakness related to heavy buying of out of the money put options, which we can see in the big skew in the options market, but these are also unlikely to be unwound anytime soon. Indeed, if anything the risk is surely that the odds of Brexit move closer to 50-50 as we approach the referendum, increasing the pressure on GBP. Personally I expect the UK will vote to stay in, but this is unlikely to be felt with any real confidence until much nearer the vote (or possibly not until after it). Incidentally, Brexit concerns should probably be best expressed by short GBP/USD or GBP/JPY as Brexit is bad for the EUR as well as GBP (albeit not as bad).

So Brexit risks still look to be to the downside for now. How about other factors? Many would argue that the relative strength of the UK economy is still a potential GBP positive, and that the focus on Brexit has only temporarily suspended the market’s demand for GBP based on a strong economy and relatively attractive interest rates (at least relative to the Eurozone). However, there are several problems with this view.

First of all, spreads are not that attractive. Sure, it looks like Brexit has created some risk premium, but 2 year spreads (swaps) have narrowed from 1.1% to 0.9% this year. The latest MPC testimony to the Treasury select committee suggested a split committee, but one where the possibility of a rates cut and/or more QE was being considered by at least 3 members (Carney, Vlieghe, Haldane) if the economy were to take a turn for the worse. Given the zero bound is not yet a factor for the UK curve, there is a lot of potential downside for UK yields in this scenario. Even so, I wouldn’t base a negative GBP view on declining yield spreads. The UK data is still reasonably robust, albeit with some weak patches, and I feel the evidence of global weakness has been somewhat overstated, with emerging markets looking much more pressured than developed markets. This may change, but for now I wouldn’t get overexcited about the scope for a UK rate cut, and the UK curve is probably pricing too dovish a view. Nevertheless, until global sentiment improves, a return of the prospect of UK rate hikes can’t be seen as a supportive factor for GBP.

But even if we take a positive view of the prospects for the UK economy and interest rates, and even if Brexit concerns don’t increase, I would argue that the upside for GBP is very limited because of the two problems of valuation and the UK current account deficit (and related budget deficit). While valuation is rarely a big factor for currencies in the short term, it is significant at extremes and the chart below of the GBP real effective exchange rate underlines that the pound is still at high levels even after the latest decline. The real trade-weighted index is still only around 10% off 2008 highs, and some 20% above 2009 lows, while in nominal terms the story is the other way around (20% off the highs, 10% off the lows), disguising the true extent of GBP strength.

gbppic

Source: BIS

But the other main consideration is the fundamental issue of the UK current account and its significance for GBP. Like valuation, the current account tends not to be a focus in developed countries in the short run, but over the long run there is  strong correlation between the current account position and a currency’s valuation. Countries with big current account surpluses tend to have currencies that trade well above Purchasing Power Parity (PPP), while those with big deficits have currencies that tend to trade below PPP. The big deterioration in the UK current account in recent years suggests it should be trading further below PPP. According to the OECD, GBP/USD PPP is 1.42 based on GDP. Given that the US has a much healthier current account and higher yields this should be seen as a ceiling, even assuming no Brexit risk. The OECD estimate of EUR/GBP PPP for GDP is a more dramatic 0.92! Given that the Eurozone is running a current account surplus of 3% of GDP while the UK has a deficit of 6% of GDP this suggests GBP is extremely expensive against the EUR from a longer term perspective. Relatively high UK yields  justify some GBP strength but only extremely negative EUR sentiment has kept GBP strong in recent years. The other implication of the relative current account positions is that while relatively strong UK growth has made UK yields more attractive, it has also sucked in imports and means the UK has a growing current account gap to finance. Strong growth funded by borrowing from abroad is not the formula for a strong currency longer term.

The conclusion is that even if the UK avoids Brexit and even if next UK move in rates is up, the still high level of the pound suggests there is more GBP weakness to come, possibly in the shape of a traditional UK balance of payments crisis.  More likely, the tightening of UK fiscal policy will restrict the current account deterioration and preclude the need for higher interest rates for some time, but this will not mean a GBP recovery, only a slower decline.

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