In recent weeks, we’ve written a lot about the euro and its recent outperformance against the dollar. It’s hardly surprising that the news has grabbed the headlines in the currency markets given that it’s the world’s most widely traded currency pair (circa 28% of global FX turnover is in EURUSD). However, the British Pound has fared even better than the euro during the same period, rising more than 14% against the dollar.

Spot Returns vs USD (23rd March 2020 to 18th August 2020)
Source: Bloomberg

Undoubtedly, there is a common theme here, notably that the dollar has come under pressure versus all its major counterparts. Since 23rd March, when the dollar index peaked during the height of the market turmoil stemming from concerns about the pandemic, the greenback has fallen more than 10% on a trade weighted basis. Of the majors, only the Brazilian Real has fallen against the dollar with underperformance almost exclusively coming from emerging market currencies.

But what about sterling? Why should it have done so well in recent months? There are three obvious reasons:

  • Valuation – The pound has been undervalued for some time now. History tells us that currencies have a tendency to revert towards fair value over the long term (3-5 years). At the height of the market turmoil in March, sterling was circa 20% undervalued against the dollar. Anything outside the +/- 20% band is fairly extreme for developed market currencies so its not surprising to see the pound recover (at ~1.31 today, we’re currently 10% undervalued).
  • Market Beta – Sterling’s performance has been highly correlated with risk assets (e.g. equity markets) in recent years. After the world’s central banks stepped in with extreme monetary stimulus to support the global economy, the world’s equity markets recovered ~50% of the COVID-19 related losses and sterling rebounded.
  • Dollar Downfall Narrative – Undoubtedly the dominant influence, however, has been the broad slide in the dollar. Uncertainty surrounding the upcoming elections, coupled with ongoing struggles relating to the spread of COVID-19 and ultra-loose monetary policy (that could yet be eased further) have all weighed on the world’s reserve currency.

The question we’re all asking now is whether the recent rally in sterling (and the decline in the dollar) will continue or if it’s likely to run out of steam? There are many analysts who favour a weaker dollar going forward, but we see three key reasons for being cautious, particularly with regards to the outlook for sterling:

  • As regular readers will know, we remain cautious about risk assets in general. With the number of COVID cases on the rise again, a breakdown in US / China trade talks, coupled with the global economic slump, we see a threat of increased volatility and a flight towards safe haven assets again in the months ahead.
  • Last week’s UK GDP figures (-20.4% q/q) while slightly better than expected, were a stark reminder of the damage COVID has done to the economy. We continue to believe that the Bank of England will try to avoid negative interest rates, but given that they’ve muted the idea, we think there is a greater chance that the MPC will take further action than the Fed (where negative rates may not be legal under the Federal Reserve Act).
  • One positive about COVID is that we haven’t had to talk about Brexit in recent months. Maybe a percentage point or two off GDP as a result of a hard Brexit is insignificant given the numbers mentioned above, but with a deal now looking unlikely before the end of the year, we find it hard to justify a bullish outlook for the pound. Round 7 of negotiations begin today covering some of the key issues where the two sides remain divided. Despite recent optimism from David Frost, we remain sceptical and share Michel Barnier’s view that a deal seems unlikely at this point. 

As is always the case, timing is everything. Yes, we favour a bearish stance on the pound in the months ahead, but given recent momentum, we shouldn’t rule out further gains in the short term. One particular point to note is that GBPUSD is testing an important resistance level in the 1.3150/00 region (see chart below). Meanwhile, the 50 day moving average is about to go above the 200 dma, a pattern known as the golden cross. Last time the this happened back in 2019, GBPUSD rallied 4.6% in the 12 days after.

Author: Marc Cogliatti