Keep pounding on Sterling?

Over at Macro Man, Macro Clown wonders if it might be time to go long GBP or at least close out shorts. Though he points readers away from GBPUSD because of dollar risk, I think it’s OK to look at how the major has evolved to see where Cable might be going. Quickly, as far as the PPP theory of exchange rates is concerned I’ll start and finish with a quote from Rudy Dornbusch “…strict versions (of PPP theory) are demonstrably wrong while soft versions deprive it of any useful content.”

For context, after its post crisis peak of about 1.71 in July of 2014 GBPUSD has been a steady decline.

Looking at rate differentials going back four years, the divergence that opened in late 2014 has persisted and indeed is at its widest at its present rate of 1.65%.

Equities tell a similar story. I indexed the S&P 500 and FTSE 100 to 100 at March 14, 2013.

Here is a table of Sharpe ratios for three time periods:

FTSE 100 S&P 500
4 Year 0.28 0.88
1 Year 1.38 1.62
Since US Election 2.64 4.60

The forward p/e of the S&P 500 is a little higher than that of the FTSE–18.27 to 13.37–but the difference doesn’t indicate a revaluation would deliver convergence. The punchline is that further portfolio flows should drive further weakness.

Last but certainly not least, the UK current account deficit is at its lowest level since data begin in 1955, and it’s not showing signs of rebounding as quickly as it did at previous local minimums. The first order effect is persistent weakness in Cable.

Finally, market positioning is net short (via the CFTC CoT reports) but at a rate that suggests there’s room for more shorts to pile on before we’re in danger of a big squeeze on a rally.

So where do we go from here? Take a simple rate differential model using the 5s back to July 2014. Here’s the scatter plot with the r-squared:

The current value of 1.65% implies about 1.11 (rounding so as not to convey a false sense of precision). Combine this with the equity return differential and the current account deficit and it’s reasonable to think we’d see a test of the 1985 low of 1.05; maybe we could even see parity. Technically, the pair has been making lower lows and lower highs in the trading range from October 2016 to present, with the recent rally looking to make a new lower high, and a following push below 1.20 could precipitate the move I’m expecting.

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