Market Update

Link to PDF

Sterling: An important point

Introduction

It is no secret that Sterling has suffered a savage fall since the start of the current financial crisis in 2007 (see the chart below). The poor state of the UK economy has become apparent and the speed and extent of the decline very dramatic. The devastating weakness of Sterling is a clear indicator of the impact the credit crisis has had on sentiment surrounding the UK economy, affecting everyone from foreign investors to domestic property holders to tourists.

We appear now to be heading into a new phase of the crisis: one where the severe banking shocks are replaced by pain in the wider economy. So, let’s assess what the prospects are for the major currencies and Sterling in particular. Have the recent, panic-stricken moves created misalignments? We all know that there are no guarantees, but are there any opportunities which, on balance, are now heavily weighted in favour of the investor?

We believe that there is a strengthening case for investors to participate in long sterling strategies over the next 18-24 months. This is not to say that we anticipate a sustained sterling rally from current levels, merely that much of the pressure for further sharp falls has abated and so the potential for rallies, albeit with a volatile background, has increased. This document attempts to clarify this view by summarising analysis from every angle: fundamental, technical, psychological and more.

Section1 – Fundamental Analysis

On the whole, the UK economy is in a dismal state and expectations going forward are poor, with figures for GDP, unemployment and inflation consistently disheartening. However, most of the UK’s negative economic news is now known and, although it is doubtful that fundamentals will improve in the near future, further damaging shocks are less likely. The experience of, and potential for, severe shocks has scared many investors away from holding sterling. Reducing the potential for further shocks is key, and means that more investors will be more relaxed about holding UK assets.

The Government’s stimulus package will take time to filter through to all levels of the UK economy, but as quantitative easing (QE) takes effect, economic figures from late 2009 onwards may well be better than currently feared. Even if (as is almost certain) the package does not create the ideal recovery, or if it leads ultimately to inflation, the sheer amount of money pumped into the economy will have some short to medium term economic benefit. The argument is that although the medicine may well not cure the patient completely, it will at least alleviate some of the symptoms. This gives the scope for “better than feared” economic data to come through later in the year, which will undoubtedly have a positive impact.

Finally, on many measures, sterling is now fundamentally cheap. More European tourists are heading to the UK and many foreign investors are eyeing UK assets whose value has tumbled sharply when compounded with the fall in sterling. For example, some UK property is now 1/3 the price it was at the peak for Japanese investors. Fundamentally, what we are saying is that sterling’s collapse has given a significant amount of easing to the UK and together with its much more flexible labour market, this should mean that exports will lead the UK out of recession faster than other countries once global demand picks up.

Whilst none of the above are arguments for significant and immediate sterling recovery, they do help provide a floor for market sentiment.

Section 2 – Technical Analysis

Technical analysis is very important in the foreign exchange markets as it is widely used by many participants. There are many different aspects but we shall concentrate on the main and most simple ones of support & resistance levels and momentum.

As demonstrated in the Bank of England chart above, sterling has fallen to levels slightly below those last seen in 1996. In other words, we have been here before and this is where the market found support before. Against individual currencies, sterling has a perceived strong support level against the dollar of “around $1.40” – many traders are happy to buy sterling there on a long term view. Against the Euro, sterling reached an equivalent of just over €1.1 (against the Deutchemark) for much of 1995. Technically there is support at current levels. Similarly, Sterling spent time in 1995 in the 130s against the Yen. The general message from this is that Sterling has traded around its current levels against the major currencies before and it has often rallied or at least stopped falling from these points historically. This provides a strong technical argument for market players to be wary of continuing to run sizeable short positions.

Momentum is a powerful tool in currency markets and provides a simple measure for those wanting to jump on any bandwagon. There are many different ways of calculating momentum but the 35-year chart below of simple momentum for Sterling against the US dollar we think shows a pretty clear message.

Section 3 – Relative Analysis

Currencies are a ‘zero sum game’, in other words if Sterling is to fall further other currencies would inevitably rise against it. However the US dollar, Euro and Japanese Yen are all in similarly dreadful states and it would not be difficult to put a case for being bearish of each one of them. So, the real issue is how much worse or better is Sterling in comparison with the other major currencies. The UK is now in the position where most of its negative news has been disclosed and the consequences felt. Sterling is able to take advantage of further bad news from other countries.

The EU has been ‘behind the curve’ for most of the financial crisis. Interest rate cuts by the ECB have been slower, and less dramatic than both the UK and USA, meaning further falls in the near future are likely as the Euro ‘catches up’. Monetary policy within the EU is affected by all members of the Euro and their political and economic situations. Disclosure of bad news is less predictable and more delayed as individual economies come to grips with their own problems at different rates. Stimulus packages take longer to be agreed and then to filter down through the constituent economies. Many Eastern European economies were less stable than their counterparts in Western Europe prior to the financial crisis and are therefore likely to have greater inherent and hidden problems: crucially, Western European banks have lent vast sums to Eastern Europe, will they be repaid in full? Hardly. Thus, Eastern Europe is a potentially significant ‘black hole’ with much more negative news still to emerge. In addition to these eastern delights, Europe has to deal with Portugal, Italy, Greece and Spain, collectively known as the “p.i.g.s.”. These have significant domestic issues with differing time horizons that will sorely test Franco-German harmony on policy. No one response will suit all parties. Potential for disharmony can only further erode confidence as no doubt will the glut of Euro denominated bonds that will almost certainly follow

The picture is also potentially poor for the USD. Before the crisis, the dollar was in a sustained downtrend. It has since benefited significantly from perceived safe-haven status, but there is a strong case for this to reverse again. US debt is by far the greatest globally and ultimately this is best eroded through devaluation. Naturally, many of the large Treasury bond holders around the world, particularly China, are keen that the dollar maintains its value, but in the end they may be forced to accept a cheaper dollar.

Section 4 – Psychological Analysis

Sterling has been condemned by both the media and market commentators during recent months, indeed the ‘demonization’ of Sterling within the markets & media has become a fashionable bandwagon. As a consequence, Sterling has plummeted into a downward spiral fuelled by overzealous analysts’ negative comments. This has led to Sterling being oversold and, by definition, an oversold status implies a forthcoming reaction to correct the imbalance. At some point, being aggressively bearish on sterling will be yesterday’s fashion and the focus will move onto other areas. Indeed, even the dreadful UK statistics announced in the recent Budget did not push Sterling down to new lows. We believe that this is a sign that fashions are shifting.

Section 5 – Market Positions

The FX market is unique in many ways, not least because of the variety of participants. Speculators, international investors, multinational corporates and central banks all play in currencies with different motives and targets.

Sterling has never (in recent years) been a significant reserve currency, so central bank holdings have been relatively low. However, many international investors have exploited the carry trade and, at its peak, there were significant holdings of the high interest rate currencies, including sterling. The savage fall in sterling has caused many bruises amongst those investors and it is widely acknowledged that the carry trade has now been unwound: so, lots of long” positions were sold, many in extreme loss or forced situations. Their absence removes a possible overhang in the market. Equally, the demonization of sterling mentioned above caused some hedge funds to take big shorts out on sterling at the beginning of the crisis, aggressively selling as the currency declined. Although there is still some bearish sentiment around, many of these positions have been closed to take profits. For those remaining shorts, we suspect that the risk is more on the upside rather than the downside and that those positions will be squeezed into any rally. In short, hedge funds play on momentum and as the negative momentum on sterling has significantly reduced, those particular hedge funds prey elsewhere. It is always possible that they will return, but selling something which is fundamentally cheap is much less appealing than selling something overvalued.

Conclusion

Sterling has fallen substantially and rapidly since mid 2007 and there were good reasons for the fall. One by one, those reasons have been superseded by new ones which suggest otherwise. Sterling was fundamentally expensive: no longer. Sterling was technically overbought: now it is oversold. The UK economy, particularly reliant on its banking sector, jumped off a cliff: the decline is now slowing due to QE. The market lurched from one shock to another: shocks are now likely to be less frequent and less severe. Sterling was the whipping-boy of the media: fashion now appears to be changing. There were many holders of Sterling in carry trades who were forced to sell: these positions have now been unwound. Sterling suffered when UK economic news was some of the worst in the world: now fears are growing about other regions, Europe in particular, taking the heat off the UK.

There is no one reason which brings us to our view of a more positive outlook for sterling over the coming two years. However, the combination of arguments outlined above does suggest a sea-change in the opinion which fuelled sterling’s decline and as such the opportunity for a rebound at some stage has grown. No doubt volatility will remain high, but employing a strategy which aims to benefit from periodic rallies in Sterling could be quite a timely investment.

Hugh Clark
Pippa Johnson

May 2009.

Contact Robert Lulham or Richard Steele at:
Arbiter Fund Managers Ltd, Multicurrency Mortgages Ltd
t 0207 491 1901
e contact@arbiterfm.com