British pound rally running out of catalysts

BY DEB SHAW | 

  • Looking at the pound against its major peers, currency remains undervalued
  • Slowing Eurozone growth, falling rate hike odds and bullish sentiment hurting pound
  • Pound rally looks set to slow as bull market runs out of catalysts

The outlook for the pound, while still bullish, is looking less optimistic today. More specifically, factors including the ongoing slowdown in regional growth, lower expectations for a May rate hike, and significant speculator interest in the currency are hampering the rally.

Following Brexit, the trade-weighted value of pound sterling (a measure of GBP relative to other currencies) hit an all-time low in October 2016. Thanks to strong European growth in 2017 and the pound’s low value, the currency has appreciated significantly since that time. This is particularly the case against the US dollar. The trade-weighted value of the pound is illustrated below for reference:

Even after recent gains, pound remains on sale

4-19-2018 GBP NEER
Source: BIS (broad nominal effective exchange rates), MarketsNow

 

As can be seen above, the pound remains significantly below its pre-Brexit values. Today, the pound is 5% below its five-year trailing average value. While a cheap valuation is one reason to buy the pound, other catalysts are looking less promising.

 

As the Eurozone slows, UK is likely to follow

Following the Brexit vote, predictions of a significant recession proved to be unfounded. Thanks to a stable underlying economy and strong growth in the Eurozone, the UK has performed well in recent history. While tailwinds from regional growth helped the pound greatly in 2017, the outlook this year is less benign. As we wrote in a recent commentary on the euro, both forward-looking indicators and actual (i.e. “hard”) data is pointing to a slowdown in the Eurozone this year. This is illustrated below:

Eurozone manufacturing sentiment and industrial production (3-month moving average)

4-13-2019 EZ PMI IP
Source: Markit, Eurostat, MarketsNow

 

As can be seen above, Eurozone manufacturing sentiment is now clearly decelerating, while industrial production is also following suit. Given the UK’s significant trading relationship with the region, a slowdown in the region will ultimately harm the British economy. As a “risk-on” currency, the pound tends to strengthen when growth is accelerating and tends to weaken during downturns.

 

Monetary policy expectations on hold

With Brexit in the back burner, the pound has also benefited from the Bank of England’s recent rate hikes. Thanks to high inflation and fairly good growth, odds for a rate hike this coming May were running at 85% earlier this week. After Governor Mark Carney stated that he was “conscious that there are other meetings over the course of this year”, the pound sold off sharply. Today, the odds of a May rate hike have fallen to around 50%.

Looking at GBP/USD, the pair started selling off around 1.43 (its latest high) following poor economic data. The pair sold off sharply following Carney’s comments, as the Bank of England is likely to be swayed by the latest figures. Between lower-than-expected inflation and wage growth, and Carney’s latest guidance, monetary policy expectations have become a smaller factor for the pound bull market.

 

Speculator sentiment starting to look stretched

The last factor working against the pound is speculator sentiment. Alongside the euro, speculators have been increasing their bullish bets on pound sterling. Looking at the latest data, net long positions in the pound are at their highest levels since July 2014. As a proportion of open interest, the current net long position is at highs last seen in April 2014. This is shown below:

Speculators buy the pound in spite of moderating momentum

4-20-2018 GBP CFTC
Source: CFTC, MarketsNow

 

As can be seen above, speculators are chasing bullish momentum in the currency, just as momentum starts to wane. As a group, speculators missed most of last year's rally, as they held on to net short positions. Despite the significant sell-off last January, total net long positions have increased in size. This is an even bigger feat considering that total interest in the pound is lower today. As a result, net long positions as a proportion of total interest has grown to 20%+, figures last seen in 2014. As the "long British pound" trade becomes a consensus idea in the investor community, future gains are likely to be more moderate as a result.  

 

Only moderately bullish today

All in all, the pound remains in a bullish trend, but is running out of positive momentum. Last year, strong regional growth, hopes for rate hikes, and excessive speculator bearishness towards the currency helped the pound strengthen by a significant degree. This year, none of these factors are supportive of a higher pound, although the currency continues to look undervalued based on its trade-weighted exchange rate.

Topics: British pound

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