Sterling: have no FEER
Peter Warburton and Nick Stamenkovic
Never underestimate the willingness or ability of economists to provide a fundamental justification for a market move. Bang on cue, the purchasing power parity charts were brought down from the attic and dusted off. A more sophisticated version is the FEER index, created by John Williamson in 1994.
The recent stellar performance of the FTSE-100 suggests investors are anticipating a boon from the tumbling pound for export-biased UK companies. Former BoE governor Mervyn King welcomed latest developments on the currency markets with open arms. Judging from record high net short positions in cable, speculators are betting on the pound continuing to head south. Gilts, on the other hand, have been on the defensive as hopes of further BoE easing vanish into the horizon.
After the initial turmoil of the post-referendum fall out, Sterling appeared to be finding its feet again, buoyed by firmer economic data and the settling of the political dust, post-Cameron. Not a bit of it. A perceived lurch towards hard Brexit at the Conservative Party conference and some hard-ball talk from Francois Hollande contributed to another sharp setback for the UK currency. Comments from UK Chancellor Hammond highlighting the unequal effects of QE added to bearish sentiment towards the pound. Is this an overblown reaction-cum-buying opportunity?
Data source: CFTC
The fundamental equilibrium exchange rate (FEER) is defined as the real trade-weighted exchange rate which is consistent with domestic and external balance, proxied by full employment and a sustainable current account balance. A currency is deemed to be overvalued if internal and/or external balances are out of kilter over the medium-term. Needless to say, by this criterion, not a single currency is appropriately valued.
The particular problem with the FEER index is its use of the current account surplus or deficit to assess external balance. The globalisation of business and the strategic location of company headquarters in lower-tax jurisdictions (think Ireland) has made a nonsense of the current balance. There are numerous reasons why current account deficits may be buffeted by factors that are immaterial to the valuation of the currency. We examined these in detail in the July UK Economic Perspective.
The raw version of the UK current account deficit is approaching 6% of GDP and tempts the interpretation that investors are attaching an additional risk premium to Sterling as a consequence. For this argument to have merit, it would be necessary for these accumulated deficits to be reflected in a negative and deteriorating net international asset position. This is far from the case. When UK foreign assets and liabilities are valued at market value rather than historic cost, the UK is a net creditor to the tune of about 30% of GDP. The UK deficit position is eminently financeable and sustainable.
Whatever ails Sterling, it finds little support from the fundamentals of UK trade. On a real effective exchange rate basis (see figure 2), the currency has seldom been less expensive than today. Rather, the foreign exchange market is attaching a large and growing discount to Sterling based on a lack of clarity over the nature of the settlement that an independent UK will achieve. Sterling is suffering from the burden of idiosyncratic risk that is unbounded in time. No-one, not even the prime minister herself, is capable of providing the necessary reassurance to the financial markets that all will be well.
Data source: BIS
Politicians are increasingly questioning the current trajectory of monetary policy. Another bout of QE by the BoE has added to nervousness about the parlous financial position of UK pension funds and heightened fears for income-constrained pensioners. ECB and BoJ sovereign purchase programmes are also under the microscope, prompting increased speculation that QE has had its last hurrah.
Fears of a post-Brexit UK slump have proven wide of the mark, lessening the clamour for further BoE action: witness latest encouraging surveys. Long drawn out negotiations between the UK and Euro officials could threaten a worsening of “animal spirits”, prompting companies to curtail investment and households to draw in their horns amid heightened uncertainty. Still, the flexibility of the UK economy and supportive policies should ensure the worst outcome is avoided.
In the absence of a definitive, line-in-the-sand, declaration, there are the following options. First, the Bank of England could turn tail and raise interest rates, citing the likelihood of an inflation over-shoot. Second, the Bank could intervene to support Sterling on the foreign exchanges, either in the spot or futures markets. Third, the Treasury could rescind its Doomsday economic prediction and start talking like a domestic finance ministry.
None of these options look particularly palatable for UK authorities. Indeed, a managed decline of the pound could sow the seeds of its own recovery, providing a welcome fillip for exports and prompting a much needed rebalancing of the UK economy, easing misplaced fears about the external position. Equilibrium of the UK currency may be close at hand.
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