Deutsche Bank's Five Reasons Why the Pound Is Overvalued
For Deutsche Bank AG strategist Oliver Harvey, momentum is shifting back in favor of a weaker sterling.
The currency's advance in the weeks since the U.K.'s High Court ruled that the official process to exit the EU can't be triggered without parliamentary approval has boosted the pound to levels that now justify betting that it will against fall against a basket of trade-weighted basket of currencies, the strategist said in research published on Monday. He cited the challenges posed by everything from politics and capital flows to the composition of China's currency reserves.
Sure enough, this morning's threat that Scotland may hold a second independence vote in the event that the U.K. loses access to Europe's single market underscored the risks on the horizon. That news drove the pound 0.8 percent lower against the Deutsche Bank trade-weighted basket, paring its gains since the High Court decision to 4.5 percent.
"While political headlines will undoubtedly make trading the pound tricky, we see good risk reward for reentering shorts on a trade-weighted-basis," Harvey wrote in Monday's note.
As bets on further declines in the U.K. currency hover close to historically low levels, here are Harvey's five reasons why it makes sense to short the pound.
The difference between U.S. and U.K. bond yields hasn't been this wide since May 2000.
"In contrast to a month ago, sterling is no longer cheap on rate differentials", Harvey noted, and on the basis of two-year spreads, its "fair value" is below 1.20 against the dollar rather than the 1.2370 it traded at at 1:53 p.m in London.
The newfound high-yield status of U.S. assets is likely to fuel demand for dollar securities at the expense of those in pounds and spreads may widen further, the strategist reckons, setting a low likelihood that the Bank of England raises interest rates next year against the Fed's apparent hawkish lurch.
Suggestions the U.K. may prioritize migration curbs over unfettered access to the single market drove a rout in the sterling and the gilt market in October. Since then investors have adopted a more sanguine approach to the U.K.'s near-term economic outlook, Harvey notes, setting the stage for whiplash if the political cycle turns.
"The market has all but priced out the risk premium introduced after Theresa May’s conference speech in early October," according to Harvey.
"Given the very messy European political calendar in the H1 (including Dutch, French and likely Italian elections), we are concerned that initial negotiations could be fractious," he wrote, referring to the many polls scheduled for the first half of next year.
Foreign purchases of gilts could soon run out of steam, given consensus projections that inflation-adjusted gross domestic product will fall next year, the strategist observes. The International Monetary Fund forecasts 1.1 percent expansion in 2017, down from a 1.8 percent projection for this year.
"Contrary to popular belief, sterling valuations are not at extremes. Indeed, versus the euro, our PPP model suggests the pound is now expensive," Harvey warns, referring to purchasing-power parity, and highlighting the downside risks should the business and political winds blow in a more challenging direction.
The dragon in the room
The U.K.'s currency is also vulnerable to a weaker yuan. Amid capital-outflow pressure Chinese foreign-exchange reserves fell by $70 billion last month — the most since January.
Beijing doesn't disclose the composition of its reserves. But Harvey reckons the pound — the third-ranked currency in total foreign-exchange reserves globally, according to the IMF — constitutes a sizable share.
As such, it may be vulnerable to a selloff if capital continues to flow out of China, the Deutsche strategist concludes. "The pound underperforms during periods of capital outflows due to its heavy share in Chinese reserves. These have picked up to the largest levels since January and our Asia strategist forecast more weakness for the renminbi into the new year."