GBP Finding the BEER. FX Insight. Challenging Times Ahead. Fair Value Estimates

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Claire Woods
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1 Global Macro FX Research October 26, 2016 FX Insight GBP Finding the BEER Challenging Times Ahead The EU/UK calendar for the year ahead is littered with many political events including many elections in Europe and possible trigger of Article-50 before end Mar We see greater risks ahead in terms of negotiations between UK and EU, post-trigger of Article-50. We expect European leaders to stand even firmer in their belief for 4 freedoms (freedom of movement of goods, services, people and capital over borders) in return for free access to EU single market while UK do not seem to show any hint of compromise especially on the freedom of movement of labor but want access to EU single market (i.e. trade freely). This period should continue to see heightened levels of FX volatility for GBP, and we do not rule out further FX swings. Fair Value Estimates Our Behavioral Equilibrium Exchange Rate (BEER) and FX Tracking models suggest that GBPUSD is within the fair value range estimates of ±1 standard deviation of the fair value point. But relative to the fair value point estimate, current level of GBPUSD spot is about 14% and 12% undervalued, via BEER and FX Tracking models, respectively for now. We do caution that fair valuation models are meant to refer to medium-to-longer term equilibrium levels, and not meant for trade recommendations. Our theoretical attempt to forecast GBPUSD exchange rate using monetary fundamentals suggest GBP could go as low as Signs of Technical Rebound in Short Term From GBPUSD monthly and weekly charts, momentum and stochastics continue to indicate a bearish bias. But shorter term technicals do show some mild signs of rebound (but these signs appear weak at this stage). Rebound may take GBPUSD towards Beyond interim support at levels put next support at GBPMYR remains in bearish trend channel. A decisive break below this key area of support could expose the cross towards levels. Resistance is at 5.40 levels. GBPSGD is now entering uncharted territories. Our technical projection suggests that the next low at 1.55 levels. Analysts Saktiandi Supaat (65) saktiandi@maybank.com.sg Christopher Wong (65) wongkl@maybank.com.sg Fiona Lim (65) fionalim@maybank.com.sg Leslie Tang (65) leslietang@maybank.com.sg SEE PAGE 11 FOR IMPORTANT DISCLOSURES

2 GBP Weakness a Combination of Many Factors Relating to Brexit GBP has been on a wild ride this year, falling by about 20% (vs. the USD) so far. The weakness this year was largely due to a combination of drivers, including market speculation for earlier than expected EU referendum date (since late 2015 to date of announcement of Referendum in Feb 2016), surprise EU referendum vote to leave the EU (on 24 Jun), speculation of BoE easing (Aug 2016), UK PM Theresa May s comments at the Conservative Party Conference (2 6 Oct) that Article 50 will be invoked before end-mar 2017, fat finger -triggered flash crash on 7 Oct (we are expecting BoE report explaining the cause of flash crash in early-nov) as well as the perception of tough talks ahead between EU and UK over Brexit, judging from recent headlines). Bottom line: UK outlook uncertainty (on foreign investment decisions, London s status as Financial Hub, potential relocation of HQs away from UK, jobs, new trade terms and relationship with EU) due to Brexit is expected to see heightened level of FX volatility and weigh on GBP outlook. Figure 1: GBP Pounded Hard by Events Relating to Brexit EU/UK Timeline Suggests Negotiations post-trigger of Article 50 Are Likely to be Challenging The EU/UK calendar for the year ahead is littered with many political events including Autumn Budget statement from UK Chancellor Philip Hammond (23 Nov) though there are market chatters that he is considering axing the annual Autumn Statement and focus on tax and spending decision on the Spring Budget instead, Italy referendum on Constitutional Reforms and Austria Presidential re-elections (4 Dec), Netherlands General Elections (15 Mar 2017), potential trigger of Article- 50 by UK (by end-mar 2017), French Presidential Elections (Apr May 2017), German Federal Elections (Aug Oct 2017). October 26,

Figure 2: Busy Political Calendar Could Lead to FX Swings Source: Maybank FX Research With many major elections lined up in Europe next year, we expect European leaders to stand even firmer in their

could undermine the future of the Euro-club. German Chancellor Merkel had said that free access to EU single market requires acceptance of the 4 freedoms.

3 Figure 2: Busy Political Calendar Could Lead to FX Swings Source: Maybank FX Research With many major elections lined up in Europe next year, we expect European leaders to stand even firmer in their belief for 4 freedoms (freedom of movement of goods, services, people and capital over borders) to avoid Far-Right parties stoking anti-eu sentiment leading to risk of Leave EU referendums (if held) could undermine the future of the Euro-club. German Chancellor Merkel had said that free access to EU single market requires acceptance of the 4 freedoms. For now, UK do not seem to show any hint of compromise especially on the freedom of movement of labor but want access to EU single market (i.e. trade freely). Nevertheless we note that such stances do change overtime. Moreover formal EU-UK talks are only expected to begin on the trigger of Article-50. Upon the trigger of Article-50, UK will have up to 2 years to negotiate new terms with EU, and we do not expect talks to conclude before end- 2017, given that EU leaders are expected to be pre-occupied with elections at home and pre-formal talks suggest some sort of deadlock, for now. EU Commission Juncker had said that Brexit to be very difficult messy negotiation leaders united and ready for dirty Brexit talks with Switzerland show EU can be tough negotiator. This period should continue to see heightened levels of FX volatility for GBP, and we do not rule out further swings. History has shown that GBP can depreciate by nearly 30% during the Global Financial Crisis in 2008, and out of the past 12 years, GBP has fallen (peak to trough in the year) in 8 of them. Figure 3: GBP Peak to Trough Decline (in %) vs USD October 26,

4 Finding the Equilibrium Given the large decline in GBP to around 31-year lows, after UK voted to leave the EU, there have been many questions and concerns on how low can the GBP go? There are market commentators wondering if GBP is heading for parity to the USD, while others are looking for a recovery towards 1.50 (vs. the USD) in We think it is anyone s call for where GBP can go to given that much uncertainty remains. We thought it will be useful to start off by assessing where GBP fair value estimate may be, based on our models. We then look at forecasting where GBP could be in the coming quarters, based on exchange rate determination model using monetary fundamentals. We next look at GBP market positioning via CFTC Commitment of Traders report and conclude this exercise by looking at technical charts for key resistance and support levels. Fair Value Models Suggest GBP is Within the Range Estimates Let us start with estimating the fair value range of GBP, we look at two models in our FX toolbox: (1) Behavioural Equilibrium Exchange rate (BEER) model to identify long run equilibrium exchange rate and (2) FX Tracking Model based on a set of 3 independent factors (which tend to be shorter-to-medium term cyclical drivers). For our first model, we used the BEER approach of MAS Staff Paper No.35 MacDonald (2004) (The Long Run Real Effective Exchange Rate of Singapore: A Behavioral Approach) to estimate the long run equilibrium path of the real effective exchange rate of Sterling Pound. We start from a position that the long-run equilibrium exchange rate (q) is a function of a number of key variables: q = f( tot, ltotta, nfa, lprop, rird, gdpd, lpcon, lfcon) Where tot represents the terms of trade of UK to her trading partners, ltotta is the log of the ratio of total trade to GDP and is a measure of openness which is expected to be negatively correlated to the real effective exchange rate. The openness variable has been used by both Edwards (1989) 1 and Baffes, Elbadawi and O Connell 2 (1997) that an increase in this variable is expected to depreciate the equilibrium value of a currency. In an internal-external balance setting, the increased openness would be represented by an upward movement of the external balance schedules, which requires a depreciation of the exchange rate. nfa is the ratio of net foreign assets to GDP and from the perspective of stock-flow consistent exchange rate model (i.e. Obstfeld-Rogoff 3 (1996) models), the nfa would be expected to be positively correlated to the real exchange rate. In the internal-external balance approach to modelling the real exchange rate, nfa would be driven by the determinants of national savings and investment and in particular, demographics and structurally fiscal balances (Alberola, et al 1 Edwards, S. (1989), Real Exchange Rates, Devaluation and Adjustment: Exchange Rate Policy in Developing Countries, (Cambridge, Massachusetts: MIT Press). 2 Baffes, J., Elbadawi, I.A. and O Connell, SA. (1997), Single-Equation Estimation on the Equilibrium Real Exchange Rate, Policy Research Working Paper No. 1800, The World Bank. 3 Obstfeld, M. and Rogoff, K. (1996), Foundations of International Economics, (Cambridge, Massachusetts: MIT Press). October 26,

5 (1999)) 4. lprop is the log of the UK property prices which have shown to be important for the equilibrium value of the UK REER. This variable is included as a proxy for wealth and is expected to be positively correlated to the exchange rate. rird is the real interest rate differentials between UK and her trading partners. gdpd is the real GDP differentials between UK and her trading partners. This variable is included as a measure of growth differentials. lpcon and lfcon represent the log of private and government consumption, respectively. We then used methods of Johansen 5 (1995) to determine both the existence of cointegration, or long run relationships, and to produce estimates of the BEER. The sample period used is 1Q 1999 to 3Q The weights of the trading partners are sourced from BoE Sterling Exchange rate Index. We used the top 10 trading partners, which represented over 90% of UK s total trade, and re-weight them accordingly. Our model estimated GBP long-run fair value at 1.42, with a range of 1.09 for the lower bound and 1.75 for the upper bound (based on 1 standard deviation). Based on our BEER approach, current level of GBP is well within our fair value range estimates but is about 13.7% undervalued relative to the fair value point estimate. Figure 4: Fair Value Estimate Range Using BEER Approach Source: Bloomberg, CEIC, Eviews, Maybank FX Research For our second model (FX Tracking shorter-to-medium term model), it aims to estimate the medium term fair value range of GBPUSD based on 4 Alberola, E., Cervero, S.G., Lopez, H. and Ubide, A. (1999), Global Equilibrium Exchange Rates: Euro, Dollar, Ins, Outs, and Other Major Currencies in a Panel Cointegration Framework, IMF Working Paper No. 99/175, International Monetary Fund. 5 Johansen, S. (1988), Statistical Analysis of Cointegration Vectors, Journal of Economic Dynamics and Control, Vol. 12, pp October 26,

6 3 cyclical factors the differential between UK and US current account to GDP ratios; 10Y bond yield differentials between UK and US adjusted for inflation and a reflation proxy defined as the ratio of World Equities (proxied by MSCI World Index) to World Government bonds (proxied by JP Morgan Global Aggregate Bond Index). We run multiple regressions for GBP/USD bilateral currency pair, on quarterly frequency data starting from 1Q 2007, using the independent variables mentioned above. Our model estimated GBP fair value at 1.39 with a range of 1.18 for the lower bound and 1.68 for upper bound (based on 1 standard deviation). Based on our FX Tracking model, current level of GBP is well within our fair value range estimates but is about 11.8% undervalued relative to the fair value point estimate. Figure 5: Fair Value Estimate Range Using FX Tracking Model Source: Bloomberg, CEIC, Eviews, Maybank FX Research We do however stress that emphasis should not be placed in where the fair value point estimate is, as statistical models do have its shortcomings (dependent on variable selection). Greater emphasis should be placed on the fair value range estimate, as a whole, to assess if current levels of GBP spot rates moved out of the upper or the lower bounds, which would then be interpreted as overvalued or undervalued, respectively. GBP Exchange Rate Forecast Using Monetary Fundamentals We next attempt to forecast GBP exchange rate, using the exchange rate determination from monetary fundamentals: an aggregate approach (Barnett and Chang 6 (2005)). This approach incorporates monetary aggregation and index number theory into exchange rate determination theory and the paper s findings show that with Divisia monetary aggregates and their user costs, monetary fundamentals explain exchange rate movement more accurately than random walk forecast. 6 Barnett, W., Chang. H.K. (2005), Exchange Rate Determination from Monetary Fundamentals: an Aggregation Theoretic Approach, Frontiers in Finance and Economics. October 26,

7 In accordance with the asset approach model of Hooper and Morton 7 or HMM (1982), the basic equation for estimation and forecasting of log exchange rates (S) is the following: S = a + a 1 (m m ) + a 2 (y y ) + a 3 (i i ) + a 4 (p p ) + a 5 ca + a 6 ca +u Where p is the CPI, y is the GDP, i is the 3-month treasury rate, ca is the current account as % of GDP, m is the Divisia money services index (obtained from BoE for UK and Centre for Financial Stability NY for US) and the foreign variables are denoted by the superscript *. We used OLS model for cointegration equation estimation over the sample period from 1Q 1999 to 3Q Given that the explanatory variables in the model are all endogenous and are nonstationary, we use error vector correction (VEC) in estimation and solve the full model in forecasting. Our model forecasts GBP/USD to be 1.12 average in the coming quarters. Based on our theoretical study above, our BEER and FX Tracking models suggest that GBPUSD is within the fair value range estimates of ±1 standard deviation of the fair value point estimates. But relative to the fair value point estimate, current level of GBPUSD spot is about 14% and 12% undervalued, via BEER and FX Tracking model, respectively for now. We do caution that fair valuation models are meant to refer to mediumto-longer term equilibrium levels, and not meant for trade recommendations. In addition, Brexit could bring about serious repercussion on the UK depending on how negotiations post-trigger of Article-50 pans out, and this may result in a structural break of the economy and thus affect the GBP fair value. And given that many uncertainties remain, it is unrealistic to assume and extrapolate projections. While our fair value models suggest GBP maybe undervalued for now, our GBPUSD theoretical model forecast using monetary fundamentals suggest GBP may have more downside towards 1.12 levels. We do not make trade recommendation based on theoretical model. The study was aimed at giving an idea on how low GBP can go, in theory, given the variables used and assumption made. Table 1: Comparison Between Different Models Fair Value Estimate Spot % Deviation BEER Model % FX Tracking Model % HMM Model for Forecasting 1.12 GBP CFTC Shorts Positioning Suggests GBP May Rebound Near Term Based on CFTC positioning data for the week ending 18 Oct, but released on 21 Oct, GBP shorts positions remained near record highs. That said there were some reduction of GBP short positions, possibly due to profit taking as GBP shorts positioning appear overstretched, by historical standards. We see risk of position short squeeze in the GBP. 7 Hooper, P., and J. Morton (1981), Fluctuations in the Dollar: A Model of Nominal and Real Exchange Rate Determination, Journal of International Money and Finance 1, October 26,

2120 levels (recent lows) before 1.1920 (123.6% fibo projection of 2001 low to 2007 high), 1.0830 (138.2% fibo).

8 Figure 6: GBP CFTC Positioning vs GBP GBP Technical Analysis From monthly and weekly charts, momentum and stochastics continue to indicate a bearish bias, with support levels possibly at levels (recent lows) before (123.6% fibo projection of 2001 low to 2007 high), (138.2% fibo). Resistance on the longer-term chart now stands at (low in 2001 and 2008). Figure 7: GBP (Monthly Chart) Remain Bearish Bias Overall October 26,

From a shorter term perspective, daily momentum and stochastics indicators do provide some mild signs of rebound (but these signs appear weak at this stage). Rebound may take GBP towards 1.2430 (23.

9 From a shorter term perspective, daily momentum and stochastics indicators do provide some mild signs of rebound (but these signs appear weak at this stage). Rebound may take GBP towards (23.6% fibo retracement of Sep high to interim lows of ). A move towards should not be ruled out. Figure 8: GBP (Daily Chart) Potential Rebound Risks Ahead GBPMYR Remains in Bearish Trend Channel The Pound has fallen by more than 20% vs the greenback this year. Weekly momentum and stochastics continue to indicate that the downtrend remains intact. Cross was last seen at 5.06 levels. Key area of support is at (76.4% fibo retracement of double-bottom in 2010 and 2013 to 2015 high). A decisive break below this key area of support could expose the cross towards levels. Resistance is at 5.40 levels. Figure 9: GBPMYR (Weekly Chart) - Vulnerable on Break Below 5 October 26,

10 GBPSGD In Uncharted Territories GBP has fallen against the SGD to all-time lows. Cross was last seen at 1.69 levels. Our longer-term chart indicates that momentum remains bearish bias while stochastics suggests that the cross is entering oversold conditions. For a currency cross that has fallen into uncharted territories, it can be a challenge to pick the next low. By technical definition, when a price reaches a fresh low or high (i.e. in uncharted territories), there can be no support or resistance based on previous price action. One way to estimate the next support level is to use Fibonacci projections or in this case, we use trend line support of the low of Feb 1985 to May 1996 to project the next potential technical support at This is however not our forecast target or trading recommendation but aim to give an estimation of where the next technical support can be, given that the cross is in uncharted territories. Figure 10: GBPSGD (Monthly Chart) Potential Technical Support October 26,

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11 DISCLAIMER This report is for information purposes only and under no circumstances is it to be considered or intended as an offer to sell or a solicitation of an offer to buy the securities or financial instruments referred to herein, or an offer or solicitation to any person to enter into any transaction or adopt any investment strategy. Investors should note that income from such securities or financial instruments, if any, may fluctuate and that each security s or financial instrument s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. This report is not intended to provide personal investment advice and does not take into account the specific investment objectives, the financial situation and the particular needs of persons who may receive or read this report. Investors should therefore seek financial, legal and other advice regarding the appropriateness of investing in any securities and/or financial instruments or the investment strategies discussed or recommended in this report. The information contained herein has been obtained from sources believed to be reliable but such sources have not been independently verified by Malayan Banking Berhad and/or its affiliates and related corporations (collectively, Maybank ) and consequently no representation is made as to the accuracy or completeness of this report by Maybank and it should not be relied upon as such. Accordingly, no liability can be accepted for any direct, indirect or consequential losses or damages that may arise from the use or reliance of this report. Maybank and its officers, directors, associates, connected parties and/or employees may from time to time have positions or be materially interested in the securities and/or financial instruments referred to herein and may further act as market maker or have assumed an underwriting commitment or deal with such securities and/or financial instruments and may also perform or seek to perform investment banking, advisory and other services for or relating to those companies whose securities are mentioned in this report. Any information or opinions or recommendations contained herein are subject to change at any time, without prior notice. This report may contain forward looking statements which are often but not always identified by the use of words such as anticipate, believe, estimate, intend, plan, expect, forecast, predict and project and statements that an event or result may, will, can, should, could or might occur or be achieved and other similar expressions. Such forward looking statements are based on assumptions made and information currently available to us and are subject to certain risks and uncertainties that could cause the actual results to differ materially from those expressed in any forward looking statements. Readers are cautioned not to place undue relevance on these forward looking statements. Maybank expressly disclaims any obligation to update or revise any such forward looking statements to reflect new information, events or circumstances after the date of this publication or to reflect the occurrence of unanticipated events. This report is prepared for the use of Maybank s clients and may not be reproduced, altered in any way, transmitted to, copied or distributed to any other party in whole or in part in any form or manner without the prior express written consent of Maybank. Maybank accepts no liability whatsoever for the actions of third parties in this respect. This report is not directed to or intended for distribution to or use by any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation. Published by: Malayan Banking Berhad (Incorporated in Malaysia) Saktiandi Supaat Christopher Wong Fiona Lim Leslie Tang Head, FX Research Senior FX Analyst Senior FX Analyst Senior FX Analyst saktiandi@maybank.com.sg wongkl@maybank.com.sg Fionalim@maybank.com.sg leslietang@maybank.com.sg (+65) (+65) (+65) (+65) October 26,

FX Insight. SGD: Playing Catch-Up To 3-Month SIBOR? MACRO FX RESEARCH Singapore. 23 Jun 2015

FX Insight. SGD: Playing Catch-Up To 3-Month SIBOR? MACRO FX RESEARCH Singapore. 23 Jun 2015 MACRO FX RESEARCH Singapore D 23 Jun 2015 FX Insight SGD: Playing Catch-Up To 3-Month SIBOR? The recent run-up in the 3-month SIBOR amid dollar strength as Fed prepares a lift-off in its fund rate while