What Is The Outlook For The British Pound?

About: Invesco CurrencyShares British Pound Sterling Trust ETF (FXB), Includes: DGBP, GBB, UGBP
by: Sankalp Soni

FXB has declined by about 11.21% from its high in April 2018.

Brexit uncertainty is still weighing down heavily on the pound.

Recent UK economic data may be supportive of a more hawkish BoE once Brexit uncertainty disappears.

The Invesco CurrencyShares British Pound Sterling Trust ETF (NYSEARCA:FXB), which tracks the British pound against the US dollar, is down by about 11.21% since April 2018. The main driver of the ETF has undoubtedly been the uncertainty and tensions regarding Brexit. Given the slide in the ETF price, let us assess whether this would be a good time to buy into the ETF.

Source: Yahoo Finance

Prospectus Review

The ETF tracks the value of the British pound against the US dollar. The strategy does not involve the use of derivatives, but simply involves buying pounds using US dollars. Consequently, the holdings of the fund do not include any futures or options, but simply consist of cash held in pounds. The annual net expense ratio of the ETF is 0.40%.

Risk Note: The trustee will sell pounds held by the trust to pay trust expenses, if any, incurred in USD, irrespective of then-current pound prices. The trust is not actively managed and no attempt will be made to buy or sell pounds to protect against or to take advantage of fluctuations in the price of the pounds. Consequently, if the trust incurs expenses in USD, its pounds may be sold at a time when the pound price is low, resulting in a negative effect on the value of the shares.

The reason I have distinctively chosen this particular ETF is due to the fact that it is the only one that offers non-leveraged exposure to the pound. Furthermore, according to data from ETFdb.com, it is also the ETF with the largest level of assets under management, and also has the highest average daily trading volume, thereby offering the best liquidity.

No-Deal Brexit Uncertainty

After months of negotiations, Prime Minister (PM) Theresa May has produced a draft Brexit deal between the UK and the EU. EU leaders have already approved the deal. However, whether the British Parliament will approve it on Dec. 11, 2018, is uncertain, especially following the resignations of Brexit Secretary Dominic Raab and Secretary of Work and Pensions Esther McVey. In fact, certain conservatives have even claimed that a no-deal Brexit (in which case the deal is rejected) would be better than a softer Brexit as proposed by the PM.

A no-deal Brexit would certainly result in negative consequences for the UK economy. Bank of England (BoE) Governor Mark Carney warned that in the worst-case scenario, GDP would fall as much 8% in Q1 2019, and unemployment would hit 7.5%. These consequences would certainly force the BoE to become extremely dovish and ensure monetary policy remains accommodative to the economy. This would surely result in the pound depreciating against the USD, and consequently drag FXB lower. Hence, for risk-averse investors, I would certainly not recommend buying long positions in FXB, at least until the Dec. 11 parliament vote on the Brexit deal.

Is Economic Data Supportive Of A Hawkish BoE?

While Brexit uncertainty definitely plays a vital role in the direction of the pound and FXB, investors must also pay attention to how the UK economy is currently performing to gain a better sense of the direction of interest rates going forward. If the parliament votes in favour of the Brexit deal, and economic data shows that the UK economy is strengthening, then the BoE could certainly go ahead with a more hawkish monetary policy, which would send the pound rallying higher, profiting FXB investors.

Manufacturing PMI came in at 53.1 for November, which beat the consensus estimate of 51.5. Note that a figure above 50 indicates positive economic expansion. November's figure also came in higher than October's 51.1. While this may reflect positive economic momentum, note that the manufacturing PMI has actually been on a declining trend this year, as shown by the figure below.

Source: Trading Economics

Though investors should note that part of this weakness has been due to Brexit uncertainty and that the trend could certainly begin to reverse once there is more economic clarity for businesses going forward.

Moreover, the core inflation rate is currently at 1.9%, which is just below the target rate of 2%. Therefore, the healthy level of inflation could also encourage the BoE to turn more hawkish once Brexit uncertainty disappears, which could potentially drive FXB higher.

Dovish US Fed

FXB tracks the pound against the US dollar, hence in order to examine the outlook for the ETF, it is essential to take into consideration factors influencing the greenback as well. Fed Chairman Jerome Powell recently made a very dovish statement, claiming that rates were just below "neutral", implying that the Fed may not raise rates very frequently for the foreseeable future, amid slowing economic growth. This will likely weaken the USD against the pound, hence may provide support to FXB.

Bottom Line

While the 11.21% decline in FXB may seem like an appealing time to buy into it, I believe there is substantial downside risk if the parliament votes against the Brexit deal on Dec. 11, and economic conditions turn for the worse. Although investors may get support from a simultaneously weakening USD, thanks to a dovish Fed, my recommendation is to wait until this uncertainty disappears. If the Brexit deal is accepted, then bullish investors will have good reasons to buy into the ETF amid greater certainty and already improving economic data, which would allow the BoE to turn more hawkish.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.