BrexitSchmexit - GBP expensive on any outcome

GBP has surprised many in Q1 2018 by rising steadily while many were looking for a sharp decline. The difficulty for the GBP bears is that the consequences of Brexit, while they may be very negative, will not be felt in earnest for another year or more. Even then, with the transition arrangements, the impact may be quite gradual.

In the meantime, the market has been focusing on the possibility of a rate rise from the Bank of England. The fact that a rise might come not so much because of strength in the economy but more because of persistent inflation and weak productivity growth which has reduced potential output ought to mean that a rate rise isn't particularly positive for GBP. But the market tends to focus on the simple, and after the sharp decline in GBP following the Brexit vote and the subsequent rate cut, the perception is that the bad news is in, and even dubious good news is supportive for GBP.

However, we are close to reaching a limit of the GBP rally, partly because any good news (debatable as it is) has now been discounted, but mainly because even with good news, there is really very little value in the pound. 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.

A good starting point to assess value is to look at where currencies are relative to Purchasing Power Parity (PPP). While currencies frequently trade a long way away from PPP, the majority of long term deviations are typically accompanied by persistent current account imbalances. Currencies from countries with large current account surpluses tend to trade at a premium to PPP while currencies of deficit countries tend to trade at a discount. In the short to medium term, this tendency can be offset by relatively high or low real interest rates.

According to the OECD, PPP for GBP/USD in 2017 was 1.42, but PPP for EUR/GBP was 0.94 and GBP/JPY was 140.So relative to PPP, GBP is trading broadly fair against the USD and somewhat expensive against the EUR and the JPY. At the same time, the UK is running a big current account deficit of more than 4% of GDP, while the Euro area and Japan are running big surpluses of 3% of GDP or more.

And while nominal interest rates are a little higher in the UK than in the Euro area and Japan, real interest rates are not. Real UK rates are a little below those elsewhere - and a lot below the US. In other words, even ignoring all the issues about Brexit, it is very hard to make a rational case for GBP strength, or even a case for GBP to be where it is now. 

So why are we here, and will GBP eventually fall sharply? Part of the story is that the market isn't necessarily rational, but essentially a creature of habit, much like the average person. So it continues to focus on nominal rate expectations when there is no other news, even when such expectations seem largely irrelevant to the big picture story.

The market also has a tendency to suffer from money illusion. So the fact that UK inflation has been higher than other major economies in recent years tends to be ignored in the short term, even though it has a big effect on the real value of the currency.

In addition, we have the transition agreement for Brexit agreed in Q1, and seasonal patterns favour GBP in both March and April. But we have now reached close to the limit of GBP value, with the pound essentially back up to pre-Brexit vote levels against all major currencies other than the EUR, which has seen independent strength.

The impact of inflation on the real exchange rate has been quite significant, particularly in GBP/JPY, but also in EUR/GBP. In 1999, EUR/GBP PPP was 0.83 - it is now 0.94 - a 13% rise. Even more dramatically, GBP/JPY PPP was 223, it is now 140 - a 37% decline. In 1999 EUR/GBP average 0.66, and GBP/JPY 184. In other words, GBP is much stronger relative to PPP now than it was then, despite a weaker current account position and lower relative real interest rates. Some of this relates to the particular situation in 1999, but as the charts below show, GBP is stronger relative to PPP against the JPY than it usually is.

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)

Essentially, 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.

Hence, 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. 

Sell GBP/JPY at 151.35 - target 135, stop 156.