AUD, GBP Most Undervalued In G10 World

In the past few months, the strong deceleration in the Chinese economic activity combined with the sharp contraction in ‘liquidity’ (Total Social Financing 12M Sum YoY change) have been weighing on the Aussie against major crosses. After peaking at 0.80 in February against the USD, the Aussie has been constantly testing new lows and is now down nearly 10% against the greenback.

AUD is now the most undervalued (-15%) currency among the G10 world according to our BEER model, which uses terms of trade, inflation and 10Y interest rate differentials as explanatory variables to compute the ‘fair’ value of currencies.

The second most undervalued currency is ‘risk-on’ GBP, standing at -13.2% from its ‘fair’ value. The rise in volatility combined with the deceleration in global liquidity have been weighing on Sterling in recent months.

On the other hand, the CHF is the most overvalued currencies against the USD (+7.7%) according to our BEER model, followed by the EUR (+3.8%). It is interesting to see that the Euro, which appears significantly undervalued from a PPP approach (PPP estimates the ‘fair’ value of EURUSD at 1.41 – implying that the EUR is over 18% undervalued), is now overvalued using a BEER approach.

Source: Bloomberg, RR calculations

Is The Selloff Coming On Sterling?

We know that Sterling has historically traded like a risk-on currency that tends to appreciate in periods of trending markets and consolidate sharply in high-volatility regime.

Figure 1 shows the monthly average performance of the most liquid currencies relative to the dollar when the VIX rises above 20 in the past 30 years. As expected, the yen is the currency that benefits the most when price volatility rises, averaging 45bps in monthly returns. On the other hand,  the pound has averaged -30bps in monthly returns when the VIX was high.

Figure 1

Source: Bloomberg, RR calculations

This was confirmed during the March 2020 panic as GBP was sold aggressively during that month with Cable reaching a low of 1.14 (down from 1.32 in early March) before starting to recover gradually (lowest level since 1985).

Figure 2 shows an interesting relationship between GBPUSD and mega-cap growth stocks since 2020 (FANG+ stocks); Sterling has significantly recovered in the past 17 months, up nearly 20% against the US Dollar. However, the momentum on Cable has halted in recent months as risky assets have shown some signs of ‘fatigue’ amid rising uncertainty over a range of risk factors (i.e. Delta variant, falling growth expectations…).

Figure 2

Source: Bloomberg

Great Chart: G10 policy rate vs. World equities

As more and more regions in developed economies have been put under a dramatic total lockdown amid growing concerns over Covid-19, central banks have started to cut rates aggressively in order to avoid a complete market meltdown. We saw in the previous week that both the Fed and the BoE held emergency meetings and cut rates by 50bps, the most since the Great Financial Crisis, benefiting from their positive benchmark interest rate to act faster than the rest of central banks. Economies already experiencing a NIRP policy (i.e. Sweden, Euro area) will probably implement or expand asset-purchase programmes in order to fight against a significant economic shock and therefore implicitly reduce their ‘shadow rate’, a rate first introduced by Fischer Black (1995) that can measure the effects of QE, to lower levels.

However, it is important to note that a significant reduction in benchmark policy rates globally has been associated with sharp equity sell-offs. This chart shows that in the previous two downturns, the GDP-weighted G10 policy rate was cut by approximately 4 percent and coincided with a global equity sell-off of 45% to 55%. Are we set for a similar story in 2020?

Chart. G10 policy rate vs. World equities (source: Eikon Reuters)