By Matein Khalid: Chief Investment Officer & Partner at Asas Capital
The epic political dramas of last week (Aunty Theresa’s Brexit plan was rejected by the House of Commons but she managed to survive a no-confidence vote by a narrow margin) strengthened the British pound, exactly as I had expected. Yet sterling has not managed to rise above 1.30 to the US dollar in the past two months and now trades at its lowest levels in the Bretton Woods era of floating exchange rate, apart from 1984 – 85, when a surge in the Reagan dollar and Arthur Scargill’s miners strike led cable to plunge to almost parity against the greenback.
I still contend that a delay in Article 50 is inevitable and will lead to a stronger sterling against both the US dollar and the Euro – at least for the proximate future. By any criteria of purchasing power parity or inflation/interest rate differentials, sterling is deeply undervalued against the US dollar, even though two-year US Treasury bond yields are significantly higher than two year UK gilts because, unlike the Powell Fed, Mark Carney’s Bank of England cannot raise its policy rate as long as Brexit lingers like a macroeconomic sword of Damocles over Britain.
It is also undeniable that the protracted, toxic politics of the Brexit has led to an increased risk premium on sterling assets as Westminster has lost its former allure of political stability. After all, the banking grandees of the City of London are as clueless about the next twist in the Brexit saga as the currency gnomes of Planet Forex and their acolytes in the Arabian desert.
It is suicidal to trade on even the most sophisticated econometric valuation model in the foreign exchange market but The Economist Big Mac index of purchasing power parity suggests the British pound is now 27% undervalued against the US dollar. This reflects the exodus of global investors from sterling and UK risk assets amid the political and economic uncertainties of Brexit, history’s most draconian economic own goal.
Sterling at 1.30 means Planet Forex disses the probability of a no deal hard Brexit, anathema to the political elites of Westminster and the financial elites of the Square Mile. The cognoscenti’s consensus in the City is for a Norwegian style Brexit. Technicals (slow stochastics) suggest sterling is overbought at 1.2990 and positioning data/FX options risk reversal all suggest traders fear downside risk. Jolly good. This only reinforces my contrarian bullish sterling call. In retrospect, 1.2700 was an ideal level to accumulate cable as the world enters “Davos week”! After all, sterling is 100 pips higher in a week in which an incumbent Tory Prime Minister suffered the most crushing defeat in a parliamentary vote in Westminster since the 1920’s.
The only rational conclusion is that the financial markets now equate a delay in the March 29 deadline to an ultimately gentler, softer Brexit. If Britain adopts the Norwegian model in its divorce from the EU, the sterling bears will be short squeezed with a vengeance as the British pound surges higher to my next near-term strategic target of 1.36. If history decrees a second referendum and no Brexit, I can envisage sterling as high as 1.45 – 1.50, a target still below its levels in the 2010 – 2016 Cameron era. Note that UK inflation has begun to accelerate to 2.1% even as High Street retail sales had the worst Christmas since 2008, when UK PLC’s biggest banking empires were technically insolvent. The protracted US Federal government shutdown, the risk of Presidential impeachment, dystopian political polarization in Washington and dovish smoke signals from the Presidents of the New York, Chicago, St. Louis and Atlatic regional Federal Reserve banks suggests that the near-term path of least resistance for cable is higher despite all the political pantomimes in the sceptered isle.
It horrified me to see 118 Conservative MP’s vote against Prime Minister May in the most important parliamentary vote since World War Two. The Tories have been divided over Europe for a generation and Europe schisms ended the political careers of Mrs. Thatcher, John Major and David Cameron. Mrs. May leads a minority government and if her government disintegrates, a general election could well follow – a scenario that could well propel Labour’s Jeremy Corbyn into 10 Downing Street. If this happens, all bets are off for sterling and the UK home price fall would morph into an ugly meltdown.