The British pound sterling, the currency of the United Kingdom, continues to remain relatively volatile. GBP FX crosses are generally still considered risky, though the market’s general perspective on GBP is balanced. That is to say, while the currency might be risky (i.e., volatile), there appear to be just as many that are optimistic on the currency as pessimistic.
A straightforward way of thinking about this, is that if you have a currency pair priced at 100, and you believe that there is a 50% chance of the price rising to 105 (by a certain future date and time), and a 50% chance of the price falling to 95, the expected value indicates that the current price of 100 represents a “fair value”.
While there are a whole host of potential risks and outcomes that markets are trying to assess and predict, this simple (albeit essentially binary) outcome is important to understand. The increased volatility implied in the second example might not show up in FX spot prices, but it does show up in implied volatility in FX options markets. In other words, it costs more money to hedge against both upside and downside.
The increased hedging cost is a characteristic of risky currencies in general, especially more exotic currencies from developing nations. This is why a Bank of America analyst, whose opinion was recently reported in the Financial Times, thought it apt to compare GBP to an emerging market currency.
GBP does share some characteristics with more conventionally risky currencies (these might include commodity currencies such as Australian dollar, as well as more risky currencies of developing nations such as the Mexican peso). On the one hand, you have political instability, in the form of the United Kingdom having detached itself from the European Union without a trade deal (which as it stands will be needed by the end of 2020, else the country will have to fall back on default WTO trade rules).
There is also a so-called “dual deficit” problem, where the country has both a substantial budget deficit (made worse by the recent COVID-19 pandemic, to which the UK government has had to respond with vigor; the country’s debt-to-GDP now exceeds 100%, which is the first time since 1963) and a substantial current account deficit. A current account deficit occurs when imports exceed exports, and this often drags down a currency’s value over time unless there are significant confounding factors and redeeming qualities that inhibit weakness.
One redeeming quality of a currency is having reserve currency status. This is one important reason why USD remains relatively strong in spite of the United States’ current account deficits, for instance. In fact, the Financial Times (via their Alphaville blog) constructed a response to their original GBP article, raising an important counter-point in that GBP is also a reserve currency.
A reserve currency is one which is used widely in international trade, and that major central banks are prepared to hold as part of their FX reserves. While USD is generally still considered the most archetypal (and leading) reserve currency, GBP is also part of the reserve currency club. We can confirm this by looking at International Monetary Fund data, which shows that in Q4 2019, claims in pounds sterling represented 4.62% of allocated reserves.
(Source: IMF data.)
The United Kingdom is also still one of the largest and wealthiest countries in the world. The fact that the 10-year gilt yield of the United Kingdom is less than 20 basis points is a testament to the fact that the country is absolutely not an emerging market. The bond market is still more than happy to provide the UK government with credit, and crucially the country and its major companies are not forced to raise USD-denominated debt (like emerging markets often do) when they need financing.
(Chart created by the author using TradingView. The same applies to all subsequent charts presented hereafter.)
Having said all this, I have written recently on Sterling (covering pairs such as GBP/CAD and GBP/USD) in which I have taken a bearish view. While the United Kingdom is not an emerging market, risks remain. The most important is perhaps the political and economic uncertainty at present, especially in light of the recent pandemic (and its response). While all countries are affected in some way, the UK’s lockdown measures (in response to pandemic risks) and its ballooning budget deficit does begin to make the economy appear highly risky in the longer term (at least, for the time being). That is especially true given that, beyond 2020, we still do not know if the UK will have a trade deal in place.
Currencies ultimately move predominantly, in the long run, on the back of long-term confidence. Large money flows from foreign direct investment is what pushes currencies higher (or in the case of a lack thereof: lower). Because of the United Kingdom’s persistent current account deficits, the country needs foreign direct investment in order for GBP to find support. As the “dual-deficit” problem remains in view, and as the 2020 year-end deadline remains in sight (with respect to any prospective UK-EU trade deal), the case for foreign direct investment is weak.
Confidence in the UK among international investors (which would include large multinationals) is therefore likely to remain well below where it would otherwise be (i.e., without a pandemic, without a recession, and with a trade deal in place that reduces long-term political and economic uncertainty). GBP may find strength in the years to come, but for now, I believe circumstances continue to favor a GBP-bearish case.
Because of the United Kingdom’s general reliance on external investment, we can almost think of GBP as a long-globalisation instrument (the same lens through which we might view commodity currencies such as AUD). Given the current economic and macro-social situation (in light of COVID-19 and the ensuing challenges it is producing for world travel, tourism, relations and investment), a ‘short-globalisation’ trade would appear to still make sense (at least in the short to medium term). GBP represents a short globalisation trade.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Source: Seeking Alpha