The GBP focus has been almost entirely on the EU referendum in recent weeks, and this has meant that the steady movement of the polls in favour of the “Remain” camp” has pushed GBP steadily – or sometimes rapidly – higher, helped by still generally short positioning. It will be hard for the market to take notice of anything other than the EU referendum until the vote on June 23, but it does seem as if the focus on this one issue has pushed GBP to levels that look out of line with fundamentals.
The simple metric of the spread between GBP and USD yields worked well until a few weeks ago as a guide to the appropriate level of GBP. But as the US data have improved slightly, global risk appetite has also recovered a touch, and the Fed have indicated that a June rate hike is very possible, US yields have risen and the spread has moved in favour of the USD. At the same time, the UK MPC now seems less convinced that the next move in rates will be up, as the evidence mounts of a slowdown in the economy, which may or may not be related to the referendum. However, GBP/USD hasn’t reacted as usual as short positioning has been unwound in response to the polls, but now there looks to be a gap between the usual yield spread relationship and the currency.
Of course, currency deviations from yield spread correlations are hardly unusual, and can often persist, but usually when there are good structural reasons. For instance, the recovery in the EUR this year has flouted the usual yield spread relationships, but the big Eurozone current account surplus and the low EUR valuation provide some justification for this. There is less case for this with GBP which is still not cheap at current levels and has no current account support – quite the opposite.
For now, it is still hard to see a major turn lower in GBP, as the focus on the polls is still complete and confidence in a “Remain” victory is still increasing. Even so, the 80% probability of a “Remain” victory now priced in will be hard to exceed by much ahead of the polls, and there is still a danger of a swing towards “Leave”. There is now purdah on civil service support for the government “Remain” campaign, so we won’t be seeing any more government produced statistics in favour of the “Remain” case. It looks as if the polls are at best a balanced risk for GBP.
This suggests to me that GBP is vulnerable here. Even if we get a “Remain” victory the fundamentals don’t suggest any case for GBP strength. Yield spreads as shown above are in the USD’s favour, and although this is not the case with EUR/GBP, the high GBP valuation and big UK current account deficit limit the scope for GBP gains against the EUR. There is no particular reason for economic optimism based on the UK data. There may of course by a knee jerk positive reaction to a “Remain” vote, but there is unlikely to be any early evidence that a vote for “Remain” has helped the economy, and there may well be political fallout to deal with related to the split in the Conservative Party that has become more obvious as the referendum campaign has gone on. So rather like Wile E Coyote in the picture above, the market should soon realise that there is nothing supporting GBP strength once the good poll news has gone, and a big drop may well result.