DB GBP Hostage To External Drivers?

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FX Daily: GBP Hostage to External Drivers?

GBP Hostage To External Drivers?

Throughout the course of last year sterling benefited from a steady stream of M&A and portfolio inflows, while also being pushed into the ranks of the high-yielding carry currencies thanks to the Bank of England's late-cycle tightening. A more interesting development over the last few months has been the steady growth in the importance of external drivers as determinants of both EUR/GBP and USD/GBP performance, with interest rate differentials and domestic drivers taking a back seat. The first chart at right looks at the correlation between GBP and both the VIX and a G10 carry basket, both of which have been rising in importance as drivers of GBP in recent months. The second chart at right shows that this has been accompanied by a partial decoupling of Sterling-Euro rate differentials from EUR/GBP, with sterling now trading at a significant discount to the `fair value' of around 0.67 which these differentials would imply.

Most of sterling weakness over the last few weeks may therefore be viewed in the context of the significant correction in G10 carry trades and a reduction in risk appetite across financial markets more generally. In addition, a flush-out of the significant GPB longs built throughout last year, recent announcements of some sizeable M&A outflows from the UK and a paring back in market expectations of interest rate hikes from the Bank of England has meant that GBP has suffered disproportionately compared to other high-yielders from the recent carry sell-off. Looking ahead into this week however, the UK data calendar may mean that domestic factors gather renewed attention, with CPI on Tuesday, the March MPC minutes on Wednesday, and retail sales on Thursday being the highlights. With the market only pricing a close to 25% chance of tightening from the Bank of England in the monetary policy meeting on April 5th (our own economist is calling for a 25bps hike), an upside surprise in some of this week's inflation or real activity numbers may give GBP some scope to realign with interest rate differentials and recoup some of its recent losses.