In the past two weeks, all the currencies depreciated significantly against the US dollar amid rising fears of a global USD shortage. The greenback was sold aggressively in the first two weeks of the sell-off, but the trend reversed sharply as investors tend to generally prefer the USD in prolonged periods of elevated price volatility. As we saw recently, the USD index strengthened by 5.5% in the past two weeks, its biggest two-week change since April 1986.
Interestingly, one particular currency that has been performing poorly in March has been the British pound. Figure 1 (left frame) shows that Cable, one of the most liquid currency pairs in the world, fell by 10.8% in the past two weeks, one of its biggest 2W drop in the history of the pair. The last time the British pound experienced such a move was in September 1992 after Black Wednesday (see more here). The overvaluation of GBP after the UK joined the ERM in 1990 combined with the elevated high interest rates led the UK into a recession in 1991, which eventually forced the UK government to withdraw the pound from the ERM in the middle of September 1992 and led to a sharp depreciation of the currency (-11% against the USD, figure 1, left frame). A 10-percent depreciation in a G4 currency is an incredible move; we usually see those moves in the EM currency market.
However, we find an interesting result after looking at the monthly performance of G9 currencies (against the USD) in periods of elevated price volatility (i.e. VIX>20). Against all expectations, the British pound is the weakest performer, averaging -30bps in months when VIX is trading above 20 (figure 1, right frame). Our first intuition was that we would find commodity currencies (i.e. AUD, CAD and NZD) at the bottom of the league, as these countries usually have higher benchmark rates relative to the major economies (US, Japan, UK or Euro area) leading to carry strategies.
On the other side, the JPY and CHF, also referred as the traditional safe havens, perform positively averaging 45bps and 12.5bps of positive returns, respectively.
The pound, a risk-on currency
Now that we saw that the pound performs weakly in periods of market stress against the USD, but also against the JPY, we can notice an interesting co-movement between GBPJPY and the World (ex-US, VEU) equities over time. We usually tend to use the Aussie as our risk-on currency, but the two times series co-move pretty well over time (figure 2, left frame). More importantly, GBPJPY and VEU co-move perfectly during the March sell-off as we can notice in figure 2 (right frame). We had the exact same pattern during the Great Financial Crisis in 2008; GBPJPY nearly halved in value between January 2008 and 2009 during the global equity sell-off.
As we know, inertia – how well a currency or other asset has performed in the past – is an important factor in investing, and practitioners tend to stick with the classical top performers in periods of high uncertainty. Hence, we cannot see any improvement in the near future even though the currency looks undervalued according to a range of fair value metrics.
The pound has been constantly depreciating against the major currencies in the past few years amid elevated uncertainty around Brexit. Consumption growth and business investments, two main components of GDP growth, have fallen significantly on the back of higher uncertainty. As a result, real growth differential, which is one of the main drivers of exchange rates, have been decreasing and leading to GBP weakness. Figure 3 (left frame) shows since June 2016 (Brexit referendum), real growth differential decreased from 0.5% to -1.3%, pressuring Cable to the downside (GBPUSD is down nearly 35 figures to 1.16). As the UK is more sensitive to the European economic slowdown, we expect the real growth differential to remain low in the medium term, hence the pair will continue to trade at ‘depressed’ levels.
Another important driver of currencies is the interest rate differential. Figure 3 (right frame) shows that the 2Y IR differential and Cable have co-moved strongly in the past cycle until the end of 2017. However, the relationship broke down in the past two years; we can notice the extreme divergence in the recent sell-off. While the 2Y IR differential contracted by 1 percent nearly back to 0 (as the move on interest rates was much more important on Treasury bonds relative to other international bonds), Cable got sold aggressively by nearly 15 figures. These extreme divergences always occur in periods of market stress and therefore could continue to persist as the VIX remains at very elevated levels.
GBP overvalued, but…
The sharp depreciation of the British pound in the past few years have brought investors’ interest as some practitioners are considering building a LT long position on GBP as it currently offers interesting risk premia. The pound looks certainly undervalued according to different fair value metrics; for instance, the current spot rate is trading 20 percent below its OECD PPP “fair value”, which some investors considered as an extreme band for a G10 currency. However, figure 4 (left frame) shows that Cable can remain undervalued for a long time before converging back to “fair” value; in addition, there were periods like in the 1980s when the pound was 40 percent undervalued against the greenback.
The recent sharp move on GBP brought the Real Effective Exchange Rate (REER) back to over 17 percent below its long-term average. This is an extreme low level as we can notice in figure 2 (right frame); however, historical events have shown that the pound could weaken even more as the volatility in markets remain high.
Hence, buying the pound on dips may not be a good strategy in this current environment, especially against the USD and the JPY.
Source: Eikon Reuters
GBP (FXB) medium-term outlook
Following the recent sell-off, FXB is currently trading at its historical low of 112 (series start in June 2008). Momentum indicators such as the MACD and moving average cross-overs are currently indicating a strong selling signal; however, we think that a little “bull” consolidation is very likely this week as the FXB is extremely oversold according to the RSI. In addition, extreme 2-week movements are historically followed by a technical consolidation.
We would not buy the dip at the moment, but we would wait for a rebound to consider shorting some.
EURGBP: We do think that there could be an opportunity on EURGBP though, as the pair is currently trading at the high of its historical range. It is interesting to see that the move was also very severe against the euro, even though the single currency is not classified as a historical safe. Figure 6 shows that EURGBP is up nearly 10 figures in the past month and traded above its ST resistance at 94 cents in the end of last week. We generally do not like to play reversals in FX, but it could be worth shorting some in case there is a USD pause in markets.
For long-term investors, they should wait for a little consolidation before starting to buy the dip again as the pound will remain vulnerable as long as volatility remains high. EURGBP could retest its historical high of 0.98 in this market.
Disclosure: I am/we are long USDCHF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.