Will Brexit Break Sterling?

Exchange rates and money markets are inextricably linked; after all you are just exchanging one form of money for another and the price of money (as an asset or liability) is tied up in the interest rate. If it was that simple, then forecasting exchange rates would just an exercise in future monetary policy changes. But it’s not that simple and so far this year there have been many examples of why this is not the case, of which sterling provides the most pertinent. There has been plenty of talk about the referendum on EU membership (dubbed ‘Brexit’) and I’m not here to enter that debate. I want to explore the implications on the currency of the vote which could well be seen this year.

Going back to the interest rate point above, what really stood out for me during January was the fact that the decline in sterling was not driven by interest rate developments. If we look at the chart of cable (GBP v. USD) against the 2 year interest rate spread (UK government bond yield minus US bond yield) then you can see there is a pretty tight relationship between the two. If the UK 2 year yield rises in relation to the US one, this normally reflects expectations of higher rates in the UK and is often accompanied by sterling appreciation against the USD. If we calculate a simple rolling 1-month correlation between the exchange rate and interest rate spreads, you can see that it’s invariably positive as a result.

That changed dramatically at the tail end of 2015 and into this year. Last month, the same correlation reached the lowest level since late 2008, when markets were facing serious dis-locations in the depths of the global financial crisis. We’re not at that stage at this current juncture, so clearly there must be something else going on that is driving down the UK currency.

There are two principle and related drivers that have been undermining the UK currency. The first is the general risk aversion being seen in global markets for much of this short year. For currencies, this has seen riskier currencies dumped in favour of less risky ones and the ones that have tended to be hit harder are those running current account deficits. In summary, they are reliant on overseas capital to fund that deficit and such investors, given the exchange rate risk, tend to be more flighty in times of trouble.

I’d like to concentrate on the current account side, because that’s where I think the fate of sterling will reside this year. It’s not about interest rates, because the Brexit debate will have no bearing on expectations there, which are for rates to remain on hold into 2017 (indeed, there is easing risk now priced). So long as there is uncertainty on the timing of the referendum and the result, then the surest winner will be uncertainty.

I think the simplest way to think of the current account is saving over investment for an economy. If you save more than you invest, an economy will run a surplus. If you invest more than you save, then you will run a deficit and you must finance that by receiving the difference from overseas investors. It’s not simply a case that running a deficit is bad for a currency and running a surplus is good. To determine the answer to that question, we have to dig a lot deeper into the types of assets being held by overseas investors in the UK (and vice versa), including a look at the returns being made on each.

For the Brexit debate, there are three main dynamics to be aware of. Firstly, the potential for domestic returns to diminish vs. overseas returns. The latest analysis from the Bank of England (Financial Stability Report, December 2015) suggests that for the past two years, overseas investors in the UK have enjoyed greater returns than UK investors overseas. Secondly, there is the risk that overseas investors just choose to reduce their holding of UK assets. It’s portfolio investments (around 25% of total) that are most vulnerable here, as they are easier to liquidate than direct investments. Thirdly, there is the risk that investors choose to hedge their currency exposure.

Naturally, exiting investments can be costly, so for the moment at least it’s more likely that we’ll see investors hedging a greater proportion. We’ve already seen the impact of such in the options market, with the sharp fall in risk reversals that span the anticipated referendum date of September this year. Put simply, this measures the relative price of puts and calls on cable, so the move down we’ve seen into the end of the year shows investors willing to pay more to hedge against a fall in sterling vs. a rise (with some adjustments).

But if we look at overseas holdings, it’s what US investors do that should be of main concern. North America holds around 45% of UK shares (end 2014 figures). If US interest rates rise later this year, then hedging costs (via carry) will reduce as investors will earn positive carry on the long USD vs. GBP position. The real bear case for sterling is a further rise in US interest rates, combined with a confirmation of a Brexit referendum this year. So whilst politicians and interest groups argue over whether the UK would be better out or in, there are strong reasons to believe that the uncertainty created will continue to bear down on the currency through much of the year.