The sterling value trade

Sterling has been by far the best performing of the major currencies in recent months, up over 6% since September on a bet that Brexit uncertainties that have bedeviled virtually every aspect of British public and economic life are about to be settled.

Traders and investors were salivating at the prospects of a big revaluation of sterling, which had moved into severely undervalued territory in recent years as markets taxed the currency with a big political risk discount. It may be, however, that sterling has already been repriced to fair value. This despite the fact that, as former Prime Minister Tony Blair pointed out last week, even if Boris Johnson's Conservatives win a solid majority Brexit will again have to be renegotiated with the EU.

Purchasing power parity

The way currency analysts come up with an economic valuation, as opposed to a market valuation, for currencies is through a calculation called purchasing power parity (PPP), which adjusts for relative local purchasing power on a vast basket of goods and services to come up with a level an exchange rate “should” be trading at based on economic fundamentals.

In practice PPP is a moving target that market exchange rates rarely actually trade at, constantly undershooting and overshooting. But PPP is used by investors and forex traders as a guide to help determine the degree to which there might be inefficiencies in market pricing from which profits could be derived.

What’s been going on with sterling is a perfect example of such an inefficiency, hammered as the currency has been ever since political risk became the overwhelming determinant of UK pound exchange rates since Brexit passage several years ago.

Undershooting

The degree to which sterling has been undershooting fair value is startling, far more against the US dollar than other major currencies. The greenback is considered to be rather severely overshooting on a PPP basis after rallying strongly over the last two years, and especially since 2010.

The recent rally in sterling may have already closed the PPP value gap for GBP/USD. The UK pound’s discount to PPP was about 18% in early September. Sterling fair value aganst the US dollar is now around $1.41 vs about $1.285 last in New York trade, which is a market discount to PPP of 12%, about the same as EUR/USD currently.

So, it appears on this basis that sterling’s ability to continue to outperform other major currencies against the US dollar may be limited on a fundamental economic basis. The pound's upside may perhaps be, however, quite substantial on a euphoria driven rally if the Conservatives win big in December.