Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The British economy political scene pound seems to be having a bit of an identity crisis. Is the pound a safe haven? Or is it a higher-beta currency that’s more sensitive to riskier markets, like commodity and equity prices?
It’s somehow both, as it turns out. In fact, sterling managed to ruin Goldman Sachs’ attempt to group G10 currency trades into categories. Really! The bank had to exclude a couple of very important GBP trades — Cable (USD/GBP) and EUR/GBP! — as outliers to make its model work.
Currencies are notoriously hard to predict. It is said that God invented FX strategists to make economists feel better about their own forecasts. But the sheer weirdness of sterling surprised both Goldman and its clients, as the strategists wrote in a Wednesday note:
Part of this surprise is related to the fact that Cable is one of the most highly traded crosses, and a popular choice for expressing cyclical optimism in the G10. The BIS’s Triennial Central Bank Survey on FX market turnover puts Sterling as the world’s 4th most traded currency, behind USD, EUR, and JPY. It is on one side of 13% of FX trades. And Cable is the 3rd most traded pair behind EUR/USD and USD/JPY. Despite Cable’s popularity, our results suggest that its behavior is fairly unique — enough to put it outside of the coverage of our clusters, which cover a wide range of macroeconomic environments.
A special relationship also makes for special forex, it seems. The other outlier sterling trades were EUR/GBP and GBP/CAD. All of the other outliers were highly correlated currency pairs, or those with clear economic drivers: AUD/NZD, AUD/CAD, NOK/SEK and EUR/SEK.
To unwind the knotty mystery of What Exactly Is Going On In Britain, the strategists first focus on the US dollar-sterling cross (fun fact, named cable after the 19th cross-Atlantic submarine cable that sent currency prices between London and NYC):
Part of the time, Cable acts like a high-beta cross. It is particularly sensitive to equities, reacting positively to rising equity prices in the US and Western Europe. And it also tends to do well when commodity prices are rising, another positive cyclical signal. However, this positive risk correlation flips with respect to rates. When rates rise, GBP tends to depreciate, like a safe-haven rather than a high-beta currency.
So when equities in the US and Western Europe rise, the pound appreciates against the dollar. Same goes for commodities. But when rates/bonds are selling off, also usually a sign of stronger global growth, the pound depreciates against the dollar.
Odd!
The strategists broaden their view, looking at macro-market moves associated with sterling’s outperformance against the dollar and the euro. They look at the periods before and after Brexit, and find that the more puzzling trends — especially the relationship between sterling strength and equity gains — have gotten stronger:
So what’s the takeaway here? It seems safe to say that the pound tends to appreciate against the dollar and euro when risky assets are performing well but interest-rate volatility is still low:
While Cable and EUR/GBP do not fit neatly into a cluster, there are environments where GBP outperforms both USD and EUR. Typically, these environments seem to be fairly low vol. This makes sense to us given that other, more cyclical G10 currencies like SEK or AUD are more likely to outperform in a high vol environment. However, even in lower vol environments, we consistently find that EUR/GBP and USD/GBP diverge in instances where (1) cyclicals vs defensives are outperforming and (2) oil prices are increasing. The rates picture is more mixed, as rates tend to be highly correlated across the G10. But we also find that the correlation of equities and yields is usually positive, denoting a positive growth shock, in the weeks heading into periods where GBP outperforms EUR and USD. It’s worth noting that Sterling’s beta to both equities and rates has changed over time, and has been mostly stronger in recent years. These changing relationships between GBP and market prices might be the reason behind why GBP sometimes looks like a high-beta currency and at others a bit more like a safe-haven.
Any Grand Geopolitical Conclusions from that are best left to people based in Blighty. Readers should feel free to interpret the bank’s conclusions in the comment box.
