The past week was dominated by the drama over Brexit. Days before Britain is scheduled to leave the EU, there is still no plan for how – or even whether – it’s supposed to take place. Several votes on the subject produced mixed results in Parliament. There seems to be a consensus in Britain for delaying the departure, but there’s nothing to say that the EU will agree to it.
Assuming that Britain does leave the EU, what’s likely to happen to the pound?
Although the pound has fallen a lot since before the referendum, remember that that doesn’t mean it’s cheap. We don’t want to commit the behavioral finance fallacy of anchoring. Just because a price used to be X and is now lower doesn’t mean it’s cheap – there’s nothing to say that X was the appropriate price to begin with.
The simplest way to value the currency is relative to its past value. For this exercise, we use the real effective exchange rate (REER), not the nominal rate. The REER is the value of the currency against all of Britain’s major trading partners, adjusted for inflation. It’s important because trade imbalances are one of the major factors moving currencies, and the real exchange rate is what affects the relative affordability of goods in different countries. We also use a long-term average – 10 years – to avoid the “anchoring” problem.
On this valuation, GBP is only 3.6% undervalued – not much, given what’s happening. In the past, 10% undervalued has sometimes been a barrier. That would mean the pound has another 6.4% to fall against the currencies of its major trading partners after inflation. On that basis, EUR/GBP could move to around £0.91 or GBP/USD to around $1.24 before the valuation became stretched.
The more theoretical way of valuing the pound would be with purchasing power parity. According to the OECD’s PPP methodology, which takes a large basket of goods and services and prices them in different countries, the pound is around 8.6% undervalued vs USD but 11.2% overvalued vs EUR. And considering that the EU is Britain’s largest trading partner (52% of total trade) it’s clear that the pound’s value relative to EUR is the more important of the two prices.
The pound has tended historically to trade rich on a PPP basis, but there’s nothing to say that it has to continue to do so. If we go by the usual rule of thumb for other currencies and see a 20% undervaluation as the limit, then that would mean EUR/GBP at £1.19. For GBP/USD to reach that level of undervaluation, it would mean going to $1.16.
If we take another approach and use the value of the currency as adjusted by the consumer price index (CPI) or producer price index (PPI), we get a slightly different result: it’s fairly valued vs EUR on a CPI basis but somewhat undervalued on a PPI basis (-10.7%). The PPI basis is the more important, since that measures the prices of internationally traded goods, which is what’s important for driving currencies back to PPP levels. On this basis EUR/GBP could go to £0.96 before hitting the 20% undervalued level that has previously been a barrier.
But these analyses are no doubt overly optimistic for GBP, because they all assume the same level of frictionless trade between the Britain and the EU. What happens when trade between the two regions – accounting for about half of Britain’s trade - starts including tariffs and all sorts of transportation delays? GBP would need to fall in order to keep British goods competitive in the EU. Not to mention that Britain’s trade agreements with other countries are also through the EU and are therefore all up for renegotiation simultaneously. This is why no matter what happens with Brexit, I believe the pound is overvalued at current levels – because the country’s current account deficit is bound to widen in the future. (Unless of course they cancel the whole thing, which is of course a possibility – albeit a narrow one, as I mentioned).
In fact, even with this level of undervaluation, the UK has one of the widest current account deficits in the world.
How does it finance this current account deficit? Most of the net inflow into the country’s financial account comes through stocks and bonds. Direct investment, which has hitherto been a large net inflow, has tapered off and is likely to go negative if Brexit uncertainty continues – that is, British-based firms are likely to spend more money setting up operations abroad to cope with the new situation than foreign firms are likely to spend setting up in Britain. (A positive number in this graph represents a net inflow of funds into Britain.)
Britain may still attract money into the stock market, because of the “Wimbledon Effect” – most of the major firms listed on the British stock exchange are international companies that aren’t dependent on the UK economy. But it’s hard to think of Britain continuing to attract money into the gilts market at the current pace after Brexit. At current levels, the country has far and away the lowest real interest rates among those countries with the widest current account deficits. Is this sustainable?
So in short, what we see is a country that has a huge current account deficit under the current trading regime and somehow manages to finance that deficit with negative real interest rates. Whether that anomalous situation can continue in the future, when economic uncertainty will increase under almost any conceivable outcome, is doubtful in my view.
The upcoming week: EU Summit, FOMC, Bank of England, PMIs
As the countdown to Brexit continues, it looks like the UK is going to try to delay leaving past the 29 March deadline. The UK apparently wants a short delay of a few months – not past the end of June – but It needs to get approval from all 27 of the other EU countries. As it stands, it looks like the EU is only willing to grant a longer extension – say until end-2020 – if Britain wants to hold another referendum or an election. This issue will come to a head when UK PM May makes her case at the EU Summit on Thursday and Friday, That will be one major focus of the market this week.
The other big focus will be the meeting of the US Federal Open Market Committee (FOMC), the rate-setting body of the US Federal Reserve, on Wednesday. The market sees no chance of a change in rates at this meeting; in fact, it’s pricing in zero chance of a rate hike and only 33% chance of a rate cut during the year.
The focus of attention will therefore be on the “dot plot,” in which the Committee members give their forecasts for rates at the end of each year. The median dot is taken to represent the FOMC’s consensus view of where rates are likely to be. Currently, the dot plot is pricing in two more rate hikes this year and one next year – quite different from what the market is assuming. Will the members stick to their guns or change their views?
Of particular interest is their forecast for “longer term.” That’s taken to be their estimate of where the “neutral rate” of interest is, the level at which monetary policy is neither helping nor hindering economic activity. Fed Chair Powell last week said fed funds were “now within the broad range of estimates of the neutral rate.” NY Fed President Williams was even more specific, saying the Fed is “right at neutral.” If they are at neutral, full employment, and more or less at their inflation target, then they’ve hit it. In that case, they’ve somehow managed to reach the Holy Grail of monetary policy: equilibrium. No reason to move rates either way for the foreseeable future. As Newton said, “a body at rest tends to stay at rest unless acted upon by some external force.”
I think that would be negative for the dollar, since it would mean no more hikes any time soon. Of course, since that’s already what the market is assuming, it might not have that big an impact. On the other hand, if the dot plot continues to forecast higher rates, that would be a big surprise to the market and probably send the dollar higher.
There’s virtually no chance of any change in policy at the Bank of England meeting Thursday. There’s no chance of a rate cut, and they’d have to be crazy to hike rates just days before the economy is scheduled to do a swan dive off the White Cliffs of Dover. As it stands, the market puts about a 60% probability on no change in rates this whole year.
Although BoE, like other central banks, would like to normalize policy, there’s really no urgency to do so as inflation is right at the target level and not accelerating (yet). Things might be different if/when the currency collapses after Brexit, but they’ll cross that bridge when they come to it.
I expect the BoE meeting will have little impact on the pound. No change in their stance will be just background noise against the sturm und drang of the countdown to Brexit.
The Swiss National Bank (SNB) also meets on Thursday. I think they win the award for the most boring monetary policy, narrowly beating out the Bank of Japan. Rates have been unchanged since January 2015 and the market currently expects virtually no change for the next two years at least.
Technically the SNB does have an inflation target, but in reality it seems to operate more with an FX target. They want to see EUR/CHF back up to 1.20. Unfortunately, it’s not happening. So they’re not going to raise rates, that’s for sure.
On the other hand, they already have the lowest interest rates in recorded history. By recorded history, I mean going back all the way to Mesopotamia and the Fertile Crescent. Further cuts are pretty much out of the question. And they don’t have a big enough bond market to start anything like the BoJ’s “yield curve control.” In any event, CHF bond yields are already negative out to 15 years, so wouldn’t be much point anyway. Basically, they can either go back to intervening in the FX market or wait for the ECB to start hiking. They’ve apparently decided on the latter course. No market impact likely.
Friday we get the preliminary purchasing managers’ indices (PMIs) for the major industrial economies (Japan, Eurozone, US). Is the world slipping into recession? It’s starting to look that way. The global manufacturing PMI is only a bit over the 50 “boom or bust” line.
Europe is particularly worrisome as German manufacturing slips further into contractionary territory. Germany is the leading economy of the EU, so when its manufacturing shows signs of slowing like this, people take notice. A further decline into below-50 territory would be negative for the euro.
The US is doing better. The US manufacturing PMI is also falling, but from a higher starting level and it’s still solidly in expansionary territory.
Finally, we also get consumer prices from Japan, the UK and Canada. Japan’s CPI never seems to change so that probably won’t be a big market mover. Britain’s CPI is still significant as the Bank of England does have room to change policy, but this week any UK economic news will just be background noise to the main event, Brexit. Canada’s CPI is an important indicator, but there’s another one out before the next Bank of Canada meeting (24 April) so it’s not crucial.
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