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

2020 onwards: struggling economy, more QE?

In the past cycle, central banks have been constantly intervening in the market to counter the strong disinflationary force coming from the 3D: Debt, Demographics, Disruption. Figure 1 shows that between the beginning of 2008 and early 2020, the assets from the major 5 central banks grew steadily by a annual pace of $1.25tr per year, for a total of $15tr in 12 years.

As a response to the Covid19 shock, central banks just printed more in order to prevent the economies from falling into a deflationary depression, which resulted in a 7-trillion-dollar increase in central banks’ assets in the past 8 months. The titanic liquidity injections resulted in a significant rebound in equities, especially in the US with the SP500 trading over 100 points above its February high.

With most of the European economies entering a second lockdown, and restrictions also expected to be announced in the US (as the elections are now over), governments will again run aggressive fiscal policies and extend the furlough schemes in order to avoid the rise of social unrest, which will result in more money printing from central banks in the coming months.

Is it as simple as this: the worst the economy gets, the better it is for stocks as it will result in more liquidity injections?

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Source: Eikon Reuters, RR calculations