Is the pound undervalued or overvalued?

1. Is the pound undervalued or overvalued?
2. Assessing the pound’s fundamental valuation
3. Speculators hold large GBP/USD short positions

Is the pound undervalued or overvalued?

The question as to whether the pound is undervalued or at fair value amid the backdrop surrounding Brexit uncertainty has been subject to debate among market participants since the European Union (EU) referendum. To this date, following the Brexit referendum, the pound has lost 16.6% of its value against the US dollar and 14.4% against the euro.

On a trade-weighted basis, the sterling trade weighted index (TWI), which measures GBP strength against basket of currencies belonging to the country’s most important trading partners and has depreciated by 13.2%. As such, conventional analysis would imply that the currency is undervalued.

Assessing the pound’s fundamental valuation

When analysing the fundamental valuation of a currency with respect to another, government bond yield differentials have previously provided a useful signal. The chart below compares GBP/USD with the 10-year bond spread between the US and UK over a three and a half year horizon, which provides an indication as to whether GBP/USD is overvalued or undervalued, as the spot rate typically converges to the valuation overtime.

As it stands, the 10-year rate differential implies that GBP/USD is undervalued by roughly 5-6%, similar to levels seen at the backend of 2016. In turn, this highlights the political risks that have undermined the pound, alongside, the elevated market pricing of a no-deal Brexit.

Another approach to analysing the relative fair value of a currency is through using long-term metrics such as purchasing power parity (PPP). In theory, the PPP is a rate that equalises the purchasing power of different currencies, through eliminating the differences in price levels between countries. This means that when comparing two currencies, a basket of goods should be priced the same in both countries.

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Over the past 30 years, the sterling PPP exchange rate has remained anchored around the $1.30 level, in which GBP/USD has only briefly traded at equilibrium since the EU referendum. Typically, the pound has been overvalued for long periods of times relative to PPP with the largest overvaluation seen in December 2007 (pound overvalued by 50%). At today’s level of $1.23 (11 September), the purchasing power parity model suggest that sterling is undervalued by over 6%.

However, the issue for traders is that a currency can stay overvalued or undervalued for a long period of time, therefore one should question where the catalysts may arrive to correct the situation. Of course, while long term metrics highlight that the pound is undervalued, that does not necessarily mean that the pound cannot continue to head lower, for example, a confirmation that the UK is heading for a no-deal Brexit is likely to cause a large economic shock and thus weigh on the pound further.

Speculators hold large GBP/USD short positions

That said, what also plays an important role is not just valuation but what is priced into the market. While the UK political disarray has continued to undermine the pound, the negative narrative has largely been priced into the currency with Commodity Futures Trading Commission (CFTC) positioning data showing that speculators hold a large net short position GBP/USD, suggesting that the pair may not easily collapse and potentially may see a larger reaction to a good deal as opposed to a no-deal.

Overall, while fundamental metrics (PPP and interest rate differentials) suggest that the pound is undervalued by as much as 6%, there is substantial uncertainty regarding the assessment of the UK’s future trading relationship with its biggest trading partner. Therefore, should the UK head towards a no-deal Brexit, the fair value of the currency could be lower than the current spot price.