Forget about Brexit for the moment. We don’t know what it will look like, when it will happen or what the global story will be when it does happen. Let’s just look at where the currencies and economies are now, and ask if that position makes sense. In the case of GBPJPY, it doesn’t.
The market is being asked to finance an annual relative current account position between the UK and Japan of more than $300bn in Japan’s favour, but is being offered no real yield advantage to do so, and GBP/JPY is already relatively expensive relative to PPP and to history. So even without worrying about Brexit, it’s pretty hard to make a case for GBPJPY to be at current levels.
GBPJPY is currently trading around 152. Is that high or low? Well, if you just look at a normal chart, you might think it’s low, because GBPJPY has been falling for the past – well – forever. Even in the past 20 years it has round about halved in value. Though it is around 30 figures above its all-time low (see chart below).
But this is entirely a nominal picture that ignores inflation. Most of the reason for GBP/JPY’s decline in recent years has been the higher inflation in the UK relative to Japan. The easiest way to illustrate this is to look at GBP/JPY relative to GBP/JPY PPP, as shown in the chart below.
Source: OECD, FX Economics
So although GBP/JPY has been falling steadily, it is now trading above PPP, and is further above PPP than its average over the last 20 years, as shown in the chart below.
Source: OECD, FX Economics
So, in real terms GBPJPY actually looks quite high compared to history.
Is this justified? Looking at the data, the simple answer is no. UK real yields are not relatively attractive. At the 10 year tenor, the nominal spread is 1.2% in favour of the UK. But the inflation differential in 2017 was 2.6%. Even though this is expected to narrow in 2018, it is still expected to be 1.6% according to OECD forecasts. So real yields actually favour Japan and the JPY (even more so at the short end of the curve where nominal spreads are smaller).
What about other determinants of cross border flows? The current account position implies a need for a cross border flow, and the UK was in deficit in 2017 to the tune of about 4.7% of GDP, while Japan was in surplus by 3.9% of GDP. This difference is only expected to narrow very marginally in 2018.
So the market is being asked to finance a relative current account position of more than $300bn, but is being offered no real yield advantage to do so, and the currency is already relatively expensive to PPP and to history. So even without worrying about Brexit, it’s pretty hard to make a case for GBPJPY to be at current levels.
If we add Brexit into the mix, it’s worth noting that GBPJPY is now above the high it traded the week before the Brexit referendum. Whatever you think about Brexit, it is pretty hard to argue that it currently justifies a stronger currency.
So much for valuation. But a large part of this story is about the weakness of the yen rather than the strength of sterling, and the weakness of the yen has historically been well correlated with positive risk appetite, reflecting the historic tendency for the surplus country to be keener to place money abroad at times of positive risk sentiment. But this makes far less sense than it used to when the real yields available outside Japan are no greater than the yields available inside Japan.
So it seems to me that these represent excellent levels to sell GBPJPY for the medium to long term. For the technical minded. 153.80 represents the 76.4% retracement of the move from the 164 May 2016 high to the 123 October 16 low.