- Further strengthening of the pound is likely with the BoE looking ready to exit QE sooner than the Fed. High inflation and broad-based growth in the UK should trigger BoE to act soon.
- UK equities are increasingly reacting negatively to a rallying pound. The dissipating crisis mode of markets is pressuring exporters to overcome the pound's revaluation fears.
- Investors who share this view may consider the following short positions on the FTSE 100, (SUK1, 2UKS, 3UKS)
The prospect of the pound strengthening further is fuelled by the BoE preparing to end QE sooner than the Fed. Contrasting the Fed's on-going commitment to buy US Treasuries is the BOE's dissipating support to buy UK Gilts. High inflation and broad-based growth are forcing it to reverse its dovish policy stance. By widening the yield differential between UK and US government bonds this way, the current macro conditions improve the pound's fundamentals. While rising Gilt yields should reflect stronger growth expectations for UK equities longer term, the negative sentiment overhanging UK's global export stocks impacted by a stronger pound may force the FTSE 100 to correct lower near term. Adding to the negative sentiment on the dollar and equities, is the continuation of the US government shutdown as failure to pass the US budget.
Presence of inflation and growth in the UK raises the prospect of BoE exiting QE sooner than the Fed
Momentum in the UK has been building recently with a strong rebound in producer sentiment readings. This year, UK Services PMI has risen from 51 to 60.5, the highest reading since 2006. Likewise, UK manufacturing sentiment has also rebounded and at 57.2, this level of upbeat expectations was last seen in March 2011. Combined with the UK's reviving construction, the broad based recovery in the UK is fostering the belief that the BoE may withdraw QE stimulus sooner than the Fed.
Unlike the US, inflation in the UK is relatively strong, hovering well above the 2% target and according to the BoE's inflation report, is expected to stay relatively elevated. In the US meanwhile, the persistent undershooting of consumer prices is preventing a deflation wary Fed from unwinding its stimulus program just yet. This is why, in the presence of significant inflation, it is more likely that the BoE may start unwinding its GBP 375bn QE stimulus since 2009, ahead of the Fed.
This should widen the yield differential between UK Gilts and US Treasuries and should provide fundamental support to the pound. Sentiment on UK export biased equities may sour and could, at least in the short term, force the FTSE 100 lower.
The dissipating crisis mode of markets pressures UK equities to overcome a stronger pound
Over the last 5 years, the negative correlation between the pound and UK equities has not been apparent because of the market distortions created by numerous crises and stimulus measures since 2008. From the subprime credit in the US, to sovereign default in Greece and the banking crisis in Spain, QE stimulus helped restore confidence in equities in much the same way as it has in commodities, bonds, bank deposits and currencies. Financial markets across most asset classes (bar precious metals) behaved in lockstep, i.e. with high positive correlation. At the height of the 2008 credit crisis UK equities closely correlated with the pound. However, in its aftermath, when risks in the banking system and credit markets started to dissipate, the markets have since progressively de-correlated from one another. This year, any news triggering a strengthening of the pound has been met by a stronger selling in UK equities, and vice versa. For instance, when worries over an inconclusive election in Italy and a banking crisis in Cyprus rattled the pound in March, the FTSE 100 rose. The weakening of the pound by 8% (versus the US dollar) helped the FTSE 100 to rally by an equivalent amount from the start of this year to 11 March. The short term price trend of the FTSE 100 has since been very much a mirror image of the movements in the GBP-USD rate. As the chart at the top demonstrated, correlations between the FTSE 100 and the GBP/USD rate have turned negative this year At around 1.60 USD, the pound is trading well below pre-crisis levels of 1.90 to 2.00 USD, a devaluation equivalent to ~16%. With the real economy and the banking system on stronger footings compared to 5 years ago, the pound has the potential to revalue by more than it already has this summer. Reinforcing the strength of the pound is what is currently undermining the sentiment in the US dollar and equities generally: the threat of a US government shutdown if the budget and higher debt ceiling is not passed. As the pound may find further support, this may be an opportunity to short the FTSE 100.