As talks over Brexit resume
The headlines are all doom and gloom
But pound traders seem
To think that the dream
Is real, helping cable to zoom

Once again, the overnight session has been uninspiring, although there seem to be a few conundrums this morning.  The most interesting one is the dichotomy between the pound’s recent performance (+0.2% today, +1.0% this week), and the headlines regarding the difficulty in reaching a Brexit deal.  Time is clearly running short as the two sides get together once again to hash out issues as wide-ranging as access to UK waters for fishing to questions over the application of state aid for companies.  Clearly, there are no easy answers, and in the end, at least one side is going to need to adjust their current views for a deal to be reached.  And arguably, this is a two-week drill, as the details need to be agreed in time for the EU summit, to be held on October 15th, in order to allow enough time for all 27 other EU members to ratify the deal.

The question at hand, though, is what is priced into the market given the pound’s current level of 1.2850.  A quick look at the pound’s price history since the historic vote back in June 2016 shows that the range of trading has been 1.1412 (reached during the initial Covid panic) to 1.5018 (reached in the first minutes after the Brexit vote when the belief was Bremain had won.)  However, if we remove the Covid panic, which was clearly an exogenous event, then the low was 1.1841, reached in October 2016 during the leadership change in the UK.

With this as our framework, it is then worthwhile looking at valuation models, none of which really line up, but perhaps offer some modest insight.  For instance, a PPP valuation based on CPI shows the pound is undervalued by less than 4%, but based on the Big Mac index, Sterling is cheap by 28.5%.  When looking at Effective Exchange rates (REER and NEER), the evidence points to the Big Mac index being a better indicator, with measures for both showing the pound is roughly 24% undervalued.  However, it hardly seems likely that the true value of the pound is near 1.70, which is what those adjustments would imply.  Finally, simply taking a longer term look at the pound’s value (1983-2020) shows that the average price is around 1.5850.  Of course, during all of this time, the UK has been a member of the EU so upon its exit, there will be a significant change in its terms of trade, even if there is a deal.

What conclusions can be drawn from this information?  No matter the backdrop, the pound is in the lowest quartile of its historic price levels, which implies the market is anticipating some bad news.  In the event of a hard Brexit, will the pound trade to new lows, below those seen in 1985?  That seems unlikely.  After all, the UK is not going to sink into the North Sea, it is simply going to change the terms on which it deals with the EU.  Rather, a hard Brexit seems more likely to see a movement toward 1.15-1.20, in my view, as long positions get squeezed and a general gloom settles over the economy, at least initially.  On the other hand, successful negotiations may well see a move toward 1.40-1.45, still undervalued based on some of the indicators, but moving back toward its long-term average.  All in all, I would estimate the market has priced in a two-thirds probability of a hard Brexit, so while further declines are possible, parity with the dollar seems unlikely.  Parity with the euro, however, could well arrive in that scenario.

Turning to the rest of the market, though, shows the entire FX complex appears out of sync with the risk framework.  Equity markets are lower throughout Europe (DAX -0.4%, CAC -0.2%, FTSE 100 -0.5%) after an uninspiring session in Asia (Nikkei +0.1%, Hang Seng -0.85%, Shanghai -0.2%).  US futures are essentially flat, although have spent the bulk of the evening session modestly lower.  Bond prices are a bit firmer this morning, at least in Europe, where Bunds, OATs and Gilts have all seen yields edge 1basis point lower on the day.  Treasury yields, however, are essentially unchanged, still right around 0.65%,

Commodity markets show oil prices softer (WTI -0.65%) but precious metals slightly firmer (Gold +0.4%).  In fact, all metals prices are a bit higher, but agricultural prices are softer.  In other words, signals here are mixed as well.

Finally, the dollar, despite what appears to be a mild risk-off session, is weaker pretty much vs. all its G10 brethren with only the JPY (-0.1%) the outlier.  Arguably, that looks more like a risk-on day than a risk-off one.  The leading gainer in the bloc is AUD (+0.7%) which has been the beneficiary of demand for AGB’s, a slightly higher confidence index reading and a change in view regarding further RBA stimulus by Westpac, one of the big four Australian banks. It should be no surprise that NZD (+0.55%) has followed the Aussie higher, but the rest of the bloc is having a solid day amidst broad-based dollar weakness.

EMG currencies are starting to show more strength at this hour, led by PLN (+1.15%), although gains in MXN (+0.9%), HUF (+0.7%) and CZK (+0.65%) are solid as well.  The zloty has been responding to comments from one of the central bank’s members, Eugeniusz Gatnar, describing near zero interest rates as hurting the economy and calling for normalization by next year.  Meanwhile, MXN seems to be benefitting from an increase in the carry trade, where despite recent volatility, the search for yield is forcing many investors to areas they would not have previously considered.  Overall, the only currencies that have been under pressure remain RUB and TRY as the escalation of fighting between Armenia and Azerbaijan weighs on their sponsors.

On the data front, there was precious little overnight, Tokyo CPI ex Fresh Food fell -0.2%, while European data was all second tier.  This morning we see Case Shiller Home Prices (exp 3.60%) as well as Consumer Confidence (90.0), however, neither of these seem likely to change views.  Of more importance, we have four more Fed speakers, although yesterday’s had little impact.  Arguably, the thing which has the market’s attention is tonight’s first presidential debate, but at this point, it is difficult to determine what type of impact it may have.  Ultimately, a change in the White House is likely to have some significant market implications, with the dollar’s value being clearly impacted.  But it is far too early to discuss this issue.

For today, it appears that the FX market is leading the equity markets, a highly unusual situation, but I expect that we will continue to see modest USD weakness while equity markets edge higher.

Good luck and stay safe
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