The curious case of the Sterling strength

Amid rising tensions over a global trade war, the US dollar has witnessed intense selling pressure over the last two weeks. Currencies such the euro, Swiss franc and the Canadian dollar have all rallied versus the greenback, but it is the cable, the British Pound (GBP), which has seen the steepest gains.

So what's behind the recent outperformance of the cable?

For investors looking at relative value in the FX universe, GBP still remains close to its all-time lows in terms of Purchasing Power Parity valuation. According to the Bank for International Settlements (BIS), the cable remains one of the cheapest currencies in G-10 on a Real Effective Exchange Rate (REER) basis.

While GBP bears may believe that the current rally within the backdrop of a broad-based US dollar sell-off may be overdone, it is important to note that a lot of negative news is still priced in the GBP-US dollar cross.

The GBP Trade Weighted Index (TWI) depreciation since the end of 2015 occurred in three major stages. The market first drew its attention to GBP risks at the end of 2015, which saw an approximately 11 per cent depreciation in TWI in four months. This was followed by the knee-jerk reaction on the night of/morning after the Brexit referendum. The final leg of the sell-off occurred in Q4 2016, where news of a possible "Hard-Brexit" emerged.

The recent up-move in the cable can be viewed as the removal of the "third-leg" or "Hard-Brexit" premia as the TWI is eight per cent higher from the lows.

From a technical standpoint, weekly charts paint a bullish picture. The cable is now 18 per cent higher from its early-2017 lows, having erased almost all of the post-referendum depreciation versus the US dollar. The 200-week moving average (wma) for GBP-USD sits at around the 1.4270 level. The pair has not traded above the 200wma since 2014 and a breakout from this level opens the doors for a possible run-up to the key psychological level of 1.5.

It should be noted that the 200wma acted as a major initial resistance for the GBP-USD after a 30 per cent depreciation during the European Exchange Rate Mechanism (ERM) exit in the early 1990s. The biggest downside risk to the sterling is the uncertainty pertaining to the political backdrop that remains in the UK. With only a year to go until Britain (likely) enters into the transition period to leave the EU, very little specifics have been agreed on for the post-transition period.

Political pundits are also pointing to the "Irish border issue" as a major potential stumbling block to the negotiations, and there remains a very real related risk of the government falling. We can see the Monetary Policy Committee (MPC) turn dovish going forward if Brexit negotiations take a turn for the worse.

Further, much of the Bank of England's hawkishness has been based on the above-average inflation data in the UK. The GBP Overnight Indexed Swap (OIS) is currently pricing in two rate hikes over the next 12 months. However, UK CPI readings have been cooling off lately. Economists at Citibank note that UK inflation has most likely peaked as the effect of GBP depreciation fades away. This could dampen the Band of England's hawkish stance going forward.

By: Vatsal Srivastava