As we are closely approaching our 1.40 target for Cable (here), we chose an interesting chart this week that shows a scatter plot of the UK equity market (FTSE 100) with GBPUSD exchange rate, using a weekly frequency since January 2009. Even though the relationship is not as clear as for Japan Equities and USDJPY (here), we can still observe a negative ‘Pavlovian‘ relationship where a cheaper currency usually implies higher equities. For instance, the British pound was massively sold post referendum (June 2016) on the back of an elevated political and economic uncertainty, high volatility and negative investors’ sentiment. Cable plunged from 1.44 a week before Brexit vote to reach a low of roughly 1.20 in October 2016 before starting its recovery in the first quarter of 2017.
One interesting observation is in the equity market; even though the FTSE 100 sold from 7,000 in April 2015 to 5,700 in February 2016 prior the event (as Cable), the post-Brexit rounds of Sterling depreciation played in favor of UK equities. However, over the past few months, the situation recovered in the UK, both the uncertainty and the volatility eased. If we look at the Economic and Political Uncertainty index, a monthly series based on newspaper coverage developed by Baker, Bloom and Davis, it is down from almost 1,200 (summer 2016) to 200, its prior Brexit average, bringing Cable’s 1M ATM implied volatility from 19 to 7.85 (here). At the same time, the 3-month 25 Delta Risk Reversal is back into the positive territory (from -6 in June / July 2016), meaning that the implied volatility on calls is more expensive than puts (here).
With an equity market closing at 7,730 on Friday and Cable at 1.3850 (flirting with the 1.39), we are curious to see if the relationship will continue this year. Hence the question is: will the Footsie break its 8,000 psychological resistance while Cable continues its momentum?
Our view is that the Bank of England may surprise the market in 2018 concerning its interest rate path. With the December 2019 short-sterling futures contract trading at 98.88 (i.e. implied rate of 1.12 by the end of 2019), market participants are currently pricing in two hikes for the next couple of years. We think that three to four hikes is more appropriate to the current economic climate, and policymakers may send a signal in the February update of its inflation forecasts, triggering some moves in the short-term interest rate market. We think that a potential move in the forward IR curves will benefit to the Sterling pound, however equities may struggle to reach new highs and break above the 8,000 level.
Chart: Cable vs. FTSE 100 (Source: Reuters Eikon)