Pound Morphing Into Emerging-Market Currency Before Brexit Vote

Correlation between the pound and EM highest since Sept. 2009

Sterling Surges As Poll Reveals Remain Lead

With just over a month until the U.K. vote on European Union membership, investors are increasing treating the pound like an emerging-market currency.

While sterling was used as a haven during the European debt crisis, the specter of a Brexit has pushed it to the other end of the spectrum. The correlation between sterling and an index of emerging-market currencies has climbed to the highest since the global financial crisis as the June 23 vote approaches. This suggests that, like developing-nation assets, the pound rallies when the market seeks riskier investments, and vice versa.

The correlation is “by no means perverse,” said Chris Scicluna, London-based strategist at Daiwa Capital Markets Europe Ltd. "Given the U.K.’s large current-account deficit and heightened domestic political risk, it is now displaying characteristics of an emerging-market economy,” Scicluna, who previously worked for the U.K. Treasury, said.

With the Bank of England, the International Monetary Fund and U.S. President Barack Obama all warning about the perils of a Brexit in recent weeks, the pound has taken the brunt of investor concern. The currency has dropped 1.6 percent versus the dollar since the end of 2015, the worst performance among its Group-of-10 peers.

The increased relationship with emerging-market currencies also highlights that the pound is more vulnerable to a selloff in the event of market turmoil. Gauges of anticipated sterling volatility have already jumped to the highest since 2010 in the run up to the vote, prompting some investors to seek to exit all their positions in the currency.

The currency was at $1.4497 on Tuesday, after touching $1.3836 in February, the lowest since 2009.

The pound periodically displays some of the signs or symptoms of an emerging-market currency, not least because of the U.K.’s “embarrassingly large current-account deficit,” according to Stephen Gallo, head of European foreign-exchange strategy at BMO Capital Markets in London. The U.K. deficit widened to 7 percent of gross domestic product in the last quarter of 2015, the largest since quarterly records began in 1955, according to the Office for National Statistics.

Gallo says he favors betting on declines in the pound until the referendum, because the result is so difficult to call and the pound has bigger potential for a move to the downside following the vote. The final weeks before the referendum will be "bumpy for markets and the pound," he said.

The 60-day correlation between the MSCI Emerging Markets currency index and a Deutsche Bank AG measure of the trade-weighted pound, was at 0.41 on Tuesday, the highest since 2009. That compares with around zero before the referendum was announced February, and about minus 0.3 in 2011. A reading of one suggests the two indexes move in lockstep.

“The increased correlation with the MSCI EM index is a notable new development,” said Daiwa’s Scicluna. “Unless we see the Remain camp win the referendum on June 23, sterling will necessarily be subject more than in the past to the whims of global market risk appetite.”

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