Is Sterling Sentiment Shifting? The Case For A Bullish GBP/USD

Sep. 16, 2019 8:10 AM ETDGBP, FXB, GBB-OLD, UDN, UGBP, USDU, UUP1 Like
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  • The GBP/USD has likely received a heavy discount due to political uncertainty surrounding Brexit.
  • However, interest rate differentials have improved dramatically through 2019.
  • It is possible that sentiment is now shifting, as the pair is finally responding to stronger U.K. rates relative to U.S. rates.
  • Should sentiment continue to strengthen, and should interest rates continue to improve, there is a good chance that GBP/USD could find its way back to the top of its current trading range (above 1.40).
  • A break below, out of this trading range and under the Brexit lows of around 1.19, would likely be contingent on a hard Brexit. Bond market confirmation would also be needed, with a (further, long-term) collapse in the interest rate spread, far away from (and far lower than) the 0.00% bound.

The British pound sterling is rising recently off prices that were mere pips away from the 2016 'Brexit announcement low.' Could prices continue to rise? In this short article I want to draw attention to the bond market since the start of 2019.

The chart below shows how the one-year yield spread (between the U.K. and the U.S. bond yields) has risen since the start of the year, which would typically be bullish for GBP/USD.

GBP/USD vs. Interest Rates

(Created using The same applies to all subsequent charts presented herein.)

The bottom panel shows the rolling daily spread between short-term rates for the U.K. and the U.S. (the higher the better for this pair). The green line on the main chart is the 20-day moving average of this one-year spread. The red horizontal line shows the Brexit announcement low (a region in which the GBP/USD pair has recently ramped). The vertical black, dashed line marks the start of 2019. The sloping black line is the GBP/USD pair's 100-day moving average.

I have discussed before how political uncertainty has had a terrible effect on Sterling sentiment. The interesting effect of this has been that no matter what the GBP/USD interest rate spread seems to manage, the political uncertainty surrounding Brexit has continually weighed down the pound; even when the short-term rates spread has improved, the market has not given GBP/USD much credit. This non-responsive and bearish price action is characteristic of large capital outflows, typical of economies that are in political upheaval.

Yet since the start of 2019, the bond market has actually given the U.K. credit. Even the 20-day moving average of the one-year interest rate spread is now making higher highs and higher lows. With GBP/USD almost hitting the 2016 low, it is now breaking out of its trading range, with the most recent trading day closing at about the 100-day moving average.

Could we go higher? The bond market does seem to be providing us with confirmation of this. However, in the week commencing September 15, 2019, I would want to see the one-year interest rate spread breaching and closing above -1.1612% (the spread closed at -1.1917% on September 13, 2019). The closer the spread gets to 0.00%, the more sensitive the GBP/USD is likely to become.

Remember that when rates are negative, it costs money to buy the currency which yields the lower rate; it makes more sense from a carry-trade perspective to borrow and sell the lower-yielding currency. Yet when the differential is tight, the carry-trade potential is weak, and so speculative activity tends to fall.

Meanwhile, with the U.S. dollar being attractive as the world's reserve currency, and highest-yielding G7 currency, there is likely "premium" built into its price, whereas Sterling has since 2016 likely received a massive discount (arising from the political uncertainty). All in all, if greater political certainty is achieved in the U.K., this discount could unwind, and the closer the interest rate spread gets to 0.00% (between the U.K. and the U.S.), the case to short the pound should (continue to) fall dramatically.

What we have here is a potentially very bullish case for the GBP/USD. Volatility and down-side retracements are likely to continue, no doubt, but over time, the pound could now find much higher levels.

How much higher? Consider that since the Brexit announcement, the pound has been trading in the range of 1.19 to 1.44. There is no reason why the pound could not find its way back to 1.40 or higher over the following months.

GBP/USD Long-term Trading RangeThere are talks by some traders of GBP/USD seeing parity, however at this juncture, this outcome would likely require a 'hard (damaging) Brexit' outcome and much lower market-priced U.K. gilt yields.

Without a hard, negative macroeconomic case for the U.K., combined with bond market confirmation, parity (i.e. GBP/USD 1.00) would be extremely unlikely.

This article was written by

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Providing commentary and analysis, principally focused on global macro, foreign exchange, and equities as an asset class. Primary interests include equity investing from an international perspective, and FX fair values.

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.

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