Sterling has, as I previously anticipated here and here, continued to depreciate as Brexit uncertainties have become increasingly priced. The TWI is now down 11% since November (GBPJPY down over 19%) while implied volatilities and risk reversals have continued rising. But Brexit effects have more recently been reinforced by renewed concerns about the UK’s current account deficit (both size and funding). GBP downsides seem likely to extend in the run-up to the 23 June EU referendum given room for Brexit concerns to increase further and greater market scepticism about UK growth prospects. EURGBP likely to rise to 0.82-0.84 with GBPUSD potentially falling to the high 1.30s, depending on Fed policy. But my existing short GBPJPY recommendation and short GBPSEK positions may be most attractive.
• Sterling has been substantially weaker than implied by interest rate differentials since the EU referendum announcement – particularly GBPJPY and EURGBP, while GBPUSD has moved more closely with rates.
• GBP weakness has broadly tracked Brexit betting odds, but has extended despite the recent (fragile) improvement in market risk appetite (see here) on renewed concerns about the 7% of GDP UK’s current account deficit.
• GBP implied volatilities around the referendum date have risen to fresh post-crisis highs, with shorter-maturity ones up notably less but longer-maturity ones also rising significantly.
• GBP risk reversals have moved sharply to price increased sterling downside – especially versus JPY, substantially against EUR and USD but less against SEK – and don’t imply any post-referendum GBP recovery.
• The 7% of GDP Q4 current account deficit was the worst on record, as was the 5.2% of GDP annual 2015 figure. That reflects weaker FDI income, driven by lower returns on UK foreign FDI assets and lower foreign earnings large UK multinationals in commodities industries. The UK current account deficit was also the worst of the major economies, while the UK also has one of largest fiscal deficits.
• Funding of the current account has become more reliant on more volatile portfolio inflows, with net FDI flows turning negative, increasing the risks in a period of substantial macro-financial uncertainty. Foreign investors, who hold 26% of Gilts, were net sellers of gilts in December, January and February.
• The UK international investment position (i.e. net asset position) has actually been improving (to only -3.5% of GDP) despite the persistent current account deficits. That reflects positive valuation effects from sterling’s depreciation and the UK external balance sheet becoming less “hedge fund” like. While this “self-insurance” property reduces the chances of UK solvency being questioned, investors will likely not give it a high weight in a high-risk scenerio.
• GBP’s previous support from UK growth-outperformance seems at risk given the continued unbalanced nature of growth (household savings ratio falling to multi-decade low), indications that Brexit uncertainties are hitting consumer and business confidence (reinforcing recent weak capex and restraining hiring) and the UK’s prospective 1% of GDP per year fiscal consolidation over the next four years.
• Market expectations of the next BoE rate hike have shifted out to end-2019 (!). While likely eventually far too dovish, rate expectations are unlikely to shift closer over the next few weeks. Weak unit labour cost growth reinforces that MPC won’t be in a hurry to raise rates.
• I remain short GBP in the run-up the 23 June EU referendum, despite increased pricing of Brexit risks. The Scottish referendum experience indicates that markets are likely to increasingly focus on Brexit risks as 23 June approaches, potential adverse macro impacts aren’t yet priced and GBP short positioning isn’t that stretched.
• My February short GBPJPY recommendation (see here), already up 7%, continues to look attractive. While further EURGBP rises also seem likely, subject to potential adverse spillover impacts onto the EA, my ongoing short EURSEK view (see here) means that short GBPSEK likely represents a better play and appears less priced. Short GBPCAD also appears attractive and is also less priced. GBPUSD downsides are likely more dependent less Fed dovishness, but Brexit uncertainties are another international reason for the Fed to stand pat in June.
• GBP will likely to bounce back upon a “remain” vote on 23 June, contrary to risk reversals, although some concerns may linker and lasting damage may have been done UK economic prospects. But GBP is likely to fall sharply on a “leave” vote – the 30% TWI fall during the financial crisis seems like a resonable template – with MPC likely more worried about the near-term growth hit than potential inflationary pressure from GBP’s fall.
As expected, growing pricing of Brexit uncertainties underpin recent GBP falls
My previous posts (see here and here) anticipated the ongoing sterling weakness in recent months. As I expected, market Brexit uncertainties have increasingly bitten, driving the 11% TWI fall since November. The March MPC minutes ackowledged this, plus the potential adverse macro impacts of the uncertaities (see below). The GBP impact is evident in several metrics.
First, while GBP has weakened across the board in recent months this has been particularly apparent against the safe-haven of the Japenese Yen (GBPJPY down 19% since November), whose 2016 risk-aversion driven strength has been reinforced by growing market doubts about the FX impacts of BoJ easing, even though the Japanese macro-financial situation looks worrying (see below).
Second, GBP has been substantially weaker than implied by interest rate differentials since the EU referendum announcement. The second chart above illustrates that for the GBP TWI this holds for both short and long rate differentials. Moreover, this pattern has been particularly apparent for the GBPJPY (see Chart below) and to a slightly lesser extent for EURGBP, consistent with safe haven and funding curreny unwind impacts respectively. By contrast, GBPUSD movements have remained relatively-closely correlated with rate differentials (see Chart below). This points to less safe haven effects and implies that further GBPUSD falls will likely require further shifting of relative BOE-Fed policy rate expectations, which seems less likely in the run-up to the EU referendum given already-stretched BOE expectations and Yellen’s dovish comments (although the chances of a June Fed hike may be underpriced, see here).
Third, sterling’s 2016 weakness has broadly tracked Brexit betting odds (see chart), as opinion polls have generally suggested a narrowing of the “remain” lead. That said, GBP’s latest weakness has occurred despite Brexit odds having fallen back a little, driven by renewed concerns about the UK current account deficit (see below). Similarly, GBP’s weakness from November to February was strongly correlated with equity price falls (and VIX rises) consistent with GBP’s strong “risk on” nature, reinforced by Brexit uncertainties. But that link has again weakned recently as GBP has continued falling despite the tentative improvement in market risk appetite (see here, although that has also waned more recently).
Impact of Brexit uncertainties has been particularly apparent in options markets
But the impact of Brexit uncertainties have been particularly marked in a substantial rises in GBP implied volatilities and GBP downside skews (risk reversals).
Specifically, GBP 3-month risk reversals have continued rising to multi-year highs (see chart). That’s especially versus JPY and USD, but less against EUR – likely due to the perceived adverse impact on Brexit on the EA. But it’s also notable that the ratios of GBP-implied volatilities to that of the other G10 currencies have also been setting fresh highs – indicating that this is largely seen as a UK-specific event. It’s also interesting that that rises in shorter-maturity volatilities have thus far been more contained – confirming the effect is driven by the risk event of a potential Brexit. But the experiences around the Scottish referendum, and to a lesser extent that General Election, indicate that they’re likely to rise sharply over the coming weeks. Finally, longer-maturity (6-month) volatilties have also picked up nearly as much as 3-month ones: markets are not pricing a quick “return to normality” after the referendum (either GBP rebounds on “remain” or it continues falling sharply on “leave”).
The story is similar with risk reversals, which have moved to sharply price in greater GBP downsides (i.e. the price of GBP puts has risen relative to that of GBP calls). And that’s again particularly apparent for GBPJPY, followed by GBPUSD and then EURGBP (with even less GBPSEK downside priced). But the very interesting thing is that 6-month GBP risk reversals are almost indistinguishable from 3-month risk reversals (play spot the difference between the two charts below!). So markets are not currently pricing a GBP rebound after the referendum. That appears overly-negative, even though I illustrate below that worries about the UK current account rationalise the latest GBP weakness and markets may start worrying more about UK growth prospects.
Record current account deficit adds to concerns, even if partly reflects EA underperformance
The 7% of GDP Q4 current account deficit was the worst on record (since 1955), as was the 5.2% of GDP annual 2015 figure (since 1948). This was, however, partly a reflection of UK outperformance and Euro Area underperformance. In particular, the latest decline was again driven by a deterioration in UK net FDI income, with the ONS highlighting that the majority refelcted lower gross UK FDI earnings (credits) of the UK’s largest 25 multinationals and the associated impact of lower commodity prices. Indeed, the rate of return on UK-owned foreign FDI has nearly halved from 8.1% in 2011 to 4.3% in 2015, largely reflecting weak Euro Area growth. And top of that gross UK FDI assets have fallen from a peak of 83% of GDP to 74% of GDP. Fewer gross UK assets earning a lower return equates to a more negative current account.
But the chart above also illustrates that higher UK gross payments (debits) on foreign gross FDI into the UK have also contributed to the record current account deficit. This again partly reflects the UK’s outperformance – the return paid on UK FDI liabilities (to foreigners) actually rose from 4.3% in 2014 to 4.8% in 2015, thereby exceeding the 4.3% return on UK FDI holdings. But that was amplified by the stock of stock of foreign FDI into the UK (i.e. UK FDI liabilities) rising to 71% of GDP from around 50% of GDP pre-crisis as the UK’s large current account deficits was partly funded by foreigners purchasing UK FDI assets (although this has worryingly changed more recently, see below).
The remaining components of UK primary income i.e. earnings from portfolio investments, have been flatter. But there’s also been a slight deterioration of the UK trade balance in the latest data, with the 2.6% of GDP goods and services deficit in Q4 was the worst in two years, as exports barely grew, alodside sub-trend import growth).
Current account funding has become more reliant on shorter-term flows
The UK current account deficit meas that the UK is borrowing money from abroad, underpinning BoE Governor Carney’s recent comment that the UK is “reliant on the kindness of strangers” and hence is vulnerable. Of course, the balance of payments accounting identities mean that a UK current account deficit will always be funded. The vulnerability question is rather about how, in terms of types of inflows and their interest rates, that such financing takes place. So it’s concerning that the rise in the current account deficit (greater funding needs) has been associated with an increased reliance on more volatile portfolio inflows (see chart). By contrast, the more stable net FDI flows have actually turned negative recently after a period of reasonably-strong net FDI inflows (see above). The second chart below demonstrates that the recent high net portfolio inflows into the UK have been driven by higher debt-related flows, with equity-related net flows neutral. And that in turn has largely reflected foreigners purchasing UK debt securities, but with UK investors also selling some of their foreign debt assets. Overall these funding shifts developments raise the vulnerabilies of the UK’s funding needs, which is ill-timed given the fragile global macro-financial situation, thereby increasing downside risks to sterling.
One crumb of confort is that the foreign ownership of UK assets isn’t particularly high internationally. Specifically, DMO data show that foreign investors hold around 26% of the stock of gilts. That said, given the on-going funding need all that is required is for foreign investors to be become more reluctant to make net purchases or hesitate about rolling over maturing positions rather than actively selling UK assets (and hence raising their risk premia). And Bank of England data show that foreign investors were net sellers of gilts in December, January and February – with that three-month sum being the second-highest on record. While such net outflows are not yet significant relative to the stock of holdings, this pattern needs to be watched carefully over the next few months. And, of course, the fact that gilt yields haven’t risen so far is a case of the dog which hasn’t barked, perhaps due to spillover effects from ECB QE, with GBP instead being the main asset price for expressing Brexit views.
UK twin deficit is unusual internationally
The UK also suffers from a “twin deficits” problem of having a large fiscal deficit in addition to the large current account deficit. This isn’t completely susprising given that a current account deficit represents domestic savings being “too low” i.e. less than and so can only be caused by a public sector deficit or a negative private sector financial balance. But the chart below illustrates that the UK position in this respect is one of the worst of the major and developing economies, even when I plot the less worrying 5.2% of GDP 2015 UK current account deficit. Specifically, there is only one country with a worse current account deficit (Colombia) and only two with worse fiscal positions (Japan and Brazil).
Net international asset position has improved with valuation effects! But markets probably won’t notice near-term
One piece of surpising better news, however, is that the UK’s UK international investment position (i.e. net asset position) has actually been improving (to only -3.5% of annual GDP) despite the UK’s persistent current account deficits (7% of GDP in Q4 alone). And it’s this net asset position which determines the solvency of the UK economy: so it doesm’t look like the UK is going bankrupt according to this surprising development! This apparent alchemy of borrowing increasingly from abroad yet becomming less indebted reflects several valuation effects, which I discussed in my Bank of England work (see here).
First, given that 90% of UK gross external assets of foreign curreny denominated but only 60% of UK gross external liabilities are so denominated, sterling depreciations generate positive valuation effects for the UK’s external balance sheet. The second chart above demonstrates that this was particularly apparent during GBP’s post-crisis plunge, when the substantial rise in UK net external assets actually moved them into positive territory. But it’s also been apparent more recently. This represents a nice “self-insurance” or “risk sharing” mechanism of the UK external position i.e.the UK balance sheet gains and foreign balance sheets lose when GBP falls, reducing the chances of self-perpetuating currency crises (unlike EM countries with substantial USD-denominated debt).
Second, the UK external balance sheet has become less “hedge fund” like (having large long risky asset positions funded by external liabilities in less risky assets like government bonds and banking sector flows). Specifically, post financial crisis the UK’s gross external asset and liability positions have both fallen by over 200pp of GDP, although they remain relatively large internationally at over 500% of GDP. The chart below shows that this mainly reflected lower gross positions in financial derivatives and the “other” category (mainly comprised of international banking sector flows). These smaller and more risk-balanced positions the UK IIP will experience less negative valuation effects when risky asset prices fall, as in recent months with China/global economy/monetary policy concerns.
And in theory such “self-insurance” properties reduces the chances of UK solvency being adversely affected by market movements. But investors may well place low weight on this underlying detailed picture relative the UK’s more immediate funding needs, especially in a high-risk environment such as a “leave” vote. The IIP data are after all released with a lag and are subject to concerns about measurement errors.
Sterling losing growth support given unbalanced growth and fiscal consolidation
A further negative for sterling is that the UK’s relatively strong growth performance, which previously encouraged expectations of BoE rate hikes would quickly following Fed moves, is looking increasingly questionable based upon recent data.
The positive news in the recent Q4 GDP data was that growth was revised up to 0.6% q/q was positive, although y/y growth of 2.1% compares to 2.8% in Q4 2014 with nominal GDP slowing more. But the underlying details provide room for concern about futuer prospects.
• Growth continues to be mainly driven by household consumption (up 0.6% q/q, 2.7% y/y). But that relatively-strong performance was accompanied by the savings rate falling to a multi-decade low of 3.8% of disposable income as real household disposable income fell 0.6% q/q and now seems less likely to grow as strongly as recently given that recruitment intentions have ticked down, in part due to Brexit uncertainties, and pay growth shows little sign of rising (despite high vacancy levels).
• The secondary support from stockbuilding (0.5pp GDP q/q growth contribution after 0.8pp in Q3) seems unlikely to persist.
• Capital investment remained weak. And BoE agents survey of investment intentions suggest further retracement, with Brexit concerns also prominent in the recent Deloitte CFO survey.
• While government consumption marginally supported Q4 growth (0. 1pp contribution), that impact seems unlikely to persist or improve given the ongoing fiscal consolidation. Specifically, the 1% of GDP fiscal consolidation per year over the next four years is the largest in the OECD.
• Net exports continued to depress growth (knocking 0.4pp off Q4 q/q growth following the -1.0pp contribution in Q3) likely reflecting weak EA demand conditions which seem unlikely to dramatically change near-term (although ECB easing should be helpful) while the boost from sterling’s recent depreciation will take time to be visible.
• The NIESR GDP estimate (which aggregates higher-frequency surveys and official data releases) shows growth falling to 0.3% q/q (versus 0.4% implied by the PMI data).
Market MPC pricing looks excessively dovish but BOE in no hurry to raise rates
Expectations of Bank of the first Bank of England rate hike have been pushed out even further because of the Brexit uncertainties – the market is now pricing end-2019 as the first hike. While likely eventually far too dovish – early-Mid 2017 looks more plausible – it’s very unlikelty that rate expectations will shift closer over the next few weeks and hence support sterling. Rather MPC are very attuned to the adverse macro impacts of Brexit risks, which I’m going to write about in more detail in a future post, and the continued disappointing wage growth. On the latter MPC have stressed that they’re more focussed on unit labour cost growth, which takes account of productivity, than wage growth per se. The latest data, released last Thursday, show whole-economy ULC growth slowing to 1.3% y/y in Q4 from 1.8% in Q3, reinforcing that MPC won’t be in a hurry to raise rates. Indeed MPC member Jan Vlieghe have previously argued that it wouldn’t take much for him to vote for a rate cut.
Remain short GBP: especially versus JPY and SEK
GBP downsides seem likely to extend in the run-up to the 23 June EU referendum, een though Brexit risks have become increasingly priced. The Scottish referendum experience indicates that markets are likely to increasingly focus on Brexit risks as 23 June approaches, potential adverse macro impacts aren’t yet priced and GBP short positioning isn’t that stretched.
My February short GBPJPY recommendation (see here), already up 7%, continues to look attractive given internal BoJ dynamics and market views on the limited impact of BoJ actions on JPY. Further EURGBP rises seem likely, with a 0.82-0.84 range looking reasonable as June 23rd gets closer, although perceptions of negative spillovers onto the EA and the EUR from Brexit uncertainties could constrain the upsides. But my ongoing short EURSEK view (based upon internal Riksbank divisions meaning that they’re unlikely to match the scale of ECB easing, see here) means that short GBPSEK likely represents a better play. It also appears less priced, according to implied volatilities and risk reversals, see above. GBPUSD also faces downsides, but they are more dependent on the Fed becoming less dovish (see above) and Brexit uncertainties are another international reason for the Fed to stand pat (even if market pricing of a June Fed hike looks a little low).