- We are long the Invesco Currency Shares British Pound Sterling Trust ETF (FXB) in anticipation of potential double-digit gains over the next 12 months.
- Real interest rate spreads between the U.K. and the U.S. have moved dramatically in the U.K.’s favour over the past year which strongly suggests pound gains.
- We also expect inflation expectations to decline in the U.K. and rise in the U.S. which should add further support to real yield spreads to the benefit of the pound.
- The U.K. has managed to run a trade surplus for most of the past six months suggesting the weaker currency is beginning to benefit the country’s external competitiveness.
We noted back in March that the British pound had considerable upside potential due to the improvement that had taken place between U.K. and U.S. real interest rate spreads, and the strong likelihood that the U.K.’s much higher level of inflation expectations would decline, creating a potential positive cycle of declining inflation expectations, rising real bond yields, and a stronger pound.
Shortly after we turned bullish the Covid-19-driven spike in global dollar demand saw cable drop to its lowest level since 1985 and the pair remains down on the year even as real rate spreads continue to move in sterling’s favour. We are long the Invesco Currency Shares British Pound Sterling Trust ETF in anticipation of potential double-digit gains over the next 12 months. While the pair will likely remain beholden to global risk sentiment, we expect to see it gradually mean revert higher in line with increasingly positive fundamental forces.
Real Bond Yield Spreads Are Increasingly Pound Positive
U.K. real interest rates remain among the lowest in the world when measured using 10-year inflation-linked bond yields, with the yield currently sitting at -283bps, a full 200bps below their U.S. counterparts. However, developed market currencies are driven by changes in real yields rather than the absolute level and this is good news for the pound as 10-year real yields have moved roughly 100bps in the U.K.’s favour over the past 12 months. The chart below shows how GBPUSD has tended to track the spread of real bond yields between the two countries and we see no reasons to expect this to change going forward.
Source: Bloomberg, Author’s calculations
We can calculate the fair value of GBPUSD based on the rate implied by real bond yield spreads. Such large divergences from fair value in the past have been closely correlated with subsequent sterling gains over the next 12 months as the chart below shows. Currently, real yield spreads suggest the pound should be trading as much as 13% above current levels.
Source: Bloomberg, Author’s calculations
Inflation Expectations To Move Further In The U.K.s Favour
The double-digit gains that sterling is priced to achieve effectively assumes that real yield spreads remain at current levels, but there are indications that they will head further in its favour as inflation expectations decline from current elevated levels. 10-year inflation expectations remain 145bps higher in the U.K. compared to the U.S.
U.K. Vs U.S. 10-Year Breakeven Inflation Expectations
In part this large spread reflects the fact that inflation-linked bond payments are linked to RPI rather than CPI in the U.K., which tends to average roughly a percentage point higher. However, even taking this into account we should see the spread of inflation expectations between the two countries move back towards the historical average of 100bps. The U.S.’s fiscal and external positions are in worse shape than the U.K. which suggests that if anything U.S. inflation should be slightly higher than the U.K over the coming years. If we are correct in expecting the spread of inflation expectations between the two countries to narrow, this would suggest further upside pressure on U.K.-U.S. real yield spreads, providing further support to the pound.
Real Effective Exchange Rate Remains Undervalued
Through supporting higher real interest rates, a reduction in inflation expectations would benefit the pound’s real effective exchange rate. Countries with deeply negative real interest rates such as the U.K. tend to have deeply undervalued real exchange rates. The pound’s real effective exchange rate remains deeply depressed from a long-term perspective and any improvement in real yields should help upward mean reversion in currency valuations. Such a move would also chime with the recent improvement in the country’s external position. The U.K. has managed to run a trade surplus for most of the past six months suggesting the weaker currency is beginning to benefit the country’s external competitiveness.
Pound’s Improved Competitiveness Benefiting Trade Balance
Source: JPMorgan, U.K. ONS
Correlation With Risk Assets Remains Elevated
The correlation between GBPUSD and risk assets generally has been extremely strong since the start of the year, and particularly since the March crash. Sterling has moved almost in lockstep with global financial stocks reflecting the importance of the financial industry in driving the currency pair. While we remain very bearish on U.S. stocks, we think that the U.S. financials, and financial stocks globally, are actually reasonably attractive and priced to outperform. This chimes with our view of gradual sterling outperformance.
GBPUSD Vs MSCI World Financials Index