Bottom line: We view GBP as undervalued and see opportunities to enter long GBP vs EUR/JPY/AUD.
The UK has begun the process of exiting from the EU customs union by triggering Article 50. The next significant event is the EU’s Brexit summit on the 29th of April, which will give markets some guidance on how negotiations will pan out and priorities of both parties. The UK governments focus will revolve around trade, transition and the exit arrangements while EU rhetoric has been concentrated around exit arrangements.
Although there is still a high level of uncertainty around the transition a hard-Brexit seems to be baked into the price. Currently GBP has primarily driven by politics but we see this driver fading as markets focus more on the positive UK economic backdrop, which has exceeded Bank of England (BoE) and market expectations thus far since the Brexit vote. UK CPI breached the BoE 2% target on the back of an upside surprise in core inflation which brought more focus back on the BoE. We note BoE McCafferty’s comments that the committee would be comfortable with inflation overshooting before they tightened monetary policy. They will only look to tighten when the economy has stabilised and a hike is warranted. However, any hawkish BoE rhetoric will give the GBP a boost while data remains positive.
We compute a Z-score using current market positioning relative to the rolling 2-year average based on the percentage of open interest. A score of +2/-2 identifies to us a period of extreme positioning that can lead to position adjustment. GBP shorts have reached extreme levels supporting our view to hold a short-term GBP bullish bias. If markets are going to take another leg lower, they will need positioning to adjust first so risk is skewed to the upside.
In summary, the 3 major risks to our bullish GBP view are;
1) UK economy deteriorates lead by consumption slowing due to inflationary pressures,
2) Global economy weakens where protectionism may be the catalyst and…
3) Euro-leaders make negotiations difficult.
Each of these risk events would result in significant GBP volatility and see trading GBP volatility as a good alternative if uncomfortable taking a directional bias.