Report highlights

Rich Excell explores the relationship between the GBP/USD market and what might drive a rotation of capital into one and out of another.

Image 1: Growth differential of UK and U.S. M2 compared to GBP/USD exchange rate

From my background in FX long ago, to the time I spent in London running a HF platform, I know that if I'm looking into the GBP/USD market, the first place I want to look is the relative growth in the M2 money supply in each country. This was always a good place to start to get a broad sense of under- or over-valuation of the exchange rate. The Bank of England and the Federal Reserve have both been on a similar path in terms of monetary policy, hiking from early 2022 until late summer of 2023. However, what could be different is the extent to which the banks in the economy are taking this monetary policy action and having it impact the amount of credit creation in the economy. While both are interdependent, in normal market conditions, outside of exogenous events, it tends to be credit creation that is the more important driver. On this front, you can see that the slightly faster relative growth rate in UK M2 since early 2023 has led to a slightly strengthening GBP relative to the USD. Will this continue?

Image 2: Relative performance of UK Gilts vs. U.S. Treasuries compared to GBP/USD (top chart); Relative performance of FTSE 100 Index vs. S&P 500 Index compared to GBP/USD (bottom chart)

I am also well aware of the old market adage that “money goes to where it is treated best.” This typically means to me that capital will rotate into the markets that are providing the best return or the higher relative yield. Looking at each chart, with the relative bond market performance at the top and the relative stock market performance on the bottom, we can see that this adage has typically proven to be true. When the UK offers higher relative yields or when the stock market offers better relative performance, we have seen the GBP outperform. When that hasn’t been the case, GBP has suffered. However, we can see that this relationship started to break down in the relative stock graph in the post-Covid period. It has also broken down in the bond market in the last 12-18 months. This leads me to ask the question of what may be driving the performance now?

Image 3: Bank of America Merrill Lynch Investment Clock

One of the things I teach my students in the Applied Portfolio Management class is that looking at the headline index can often be misleading. Sometimes we take comfort in the performance of the broad index, even though the sector’s performance is giving us signs of trouble. Other times, we can tell from the relative performance of sectors, that things are not as bad as they seem. One framework which I use in class, which has been around for more than a decade, is the Investment Clock. This framework was first introduced to me by BAML in 2009. The chart above gives a good pictorial representation of the framework. The idea here is that we can break the performance of the economy into four phases characterized by whether growth is rising or falling and whether inflation is rising or falling. Empirically, we have observed a difference in performance within the sectors of an index based on the phase the economy is in, i.e., whether growth is rising or falling and whether inflation is rising or falling. This relative performance is driven by the characteristics of the companies within the sector – high leverage or low leverage, high fixed cost or low fixed cost and economically sensitive or not. Once we characterize what the economy is going to do in the coming months, an investor can decide where their money should be allocated at a sector level and rotate their investment as such. In spite of certain sectors being strongly in favor through the years, this Investment Clock framework remains a steady and accurate first order approximation of what we can expect.

Image 4: Relative sector weights in UK and U.S. and identification of which sectors work in each phase

If I use this framework, and not only think about any given index such as a broad UK stock index or a broad U.S. stock index, I can start to extend to not only what will work at a sector level, but what should work at a country level considering the relative weighting of each sector within the tradable index. I have those sector weightings and the differences calculated in the spreadsheet above. We can see that the UK indices have a higher weighting on sectors such as basic materials, consumer staples, energy and financials. The U.S. market has a higher weighting on sectors such as tech, communications and consumer discretionary. Given the names most focused on in the UK are Unilever, HSBC, BP, Shell, Glencore or Barclays, while in the U.S. they are Meta, Alphabet, Apple, Amazon and Nvidia, these relative weightings probably come as no surprise. 

On the right side of the spreadsheet, I have used the Investment Clock framework to identify the sectors that should work in each of the phases that framework uses. I add up the differential sector performance in the total line to show whether the UK indices are more positively or negatively exposed, on a relative basis, in that phase. What we can see from this approach is that UK stocks do better in reflation and stagflation while the U.S. stocks do better in recovery and overheat. I want to focus in particular on the overheat vs. stagflation portion, as this is an inflection point where we would go from a U.S. advantage to a UK advantage. This inflection would be if inflation stays high and growth starts to weaken as a result. In this scenario, we can see the UK’s higher weighted sectors would do better. In the status quo, or one where growth stays strong but inflation starts to fall, the so-called “soft landing", this is a time when U.S. stocks tend to do better. This framework can help them decide, based on their economic view, which market may be the one where “capital is treated better.”

Image 5: GBP/USD compared to CRB Index (top chart) and Gold and Silver (bottom chart)

What would help us determine a view on whether inflation might be rising or falling from here? One metric market practitioners like to use is the price of commodities. In the top chart above, I compare the performance of the CRB index to GBP/USD FX rate. As commodities move higher, and take inflation with it, GBP does better on a relative basis. As commodities move lower, and take inflation lower, GBP does worse on a relative basis. 

Within the commodity market, the two places that this might be most pronounced right now are in gold and silver. These may be the purest forms of the expression, as other commodities may be more heavily influenced by geopolitics, Chinese growth or seasonality/weather. When we look at gold and silver compared to GBP/USD, we see the same relationship. As the metals move higher, GBP does better on a relative basis and vice versa. 

Image 6: Generic first contract for GBP technical chart

Putting these last few charts together, one might suggest that as the market is more focused on higher inflation; as we may see in markets such as metals, GBP does better. This could well be because of the relative sector performance in the UK vs. U.S. stock markets, seeing money flow into one and out of the other. While we have not seen a move higher in the GBP just yet, we are starting to see a stronger technical chart over the last six months or so. Over this period, we have seen a series of higher lows. In addition, we have recently seen GBP move above both the 50 and 200 day moving averages, pointing to the possibility of a move higher coming. I didn’t draw the trendlines on this chart, but you may be able to tell that GBP futures are forming a pennant pattern over the last year with the trendline lower coming in around 1.2800 and the trendline higher coming in near 1.2400. As these trendlines begin to narrow, the possibility of a breakout from this pennant pattern could be suggesting a move outside of this range that we have been in for all of 2024.

Image 7: CVOL for FX

Turning our eyes to the options market, the first stop, as always, is the CVOL Index. From here we can quickly gather some information on how the market views the current market structure. As we can see, across the board, FX vols are at or near the lows of the last year. In spite of concerns or hopes for changing central bank policies, there does not appear to be any sense of nervousness in the options market at this time, as the cost of insurance is quite low, relatively speaking.

Image 8: CVOL vs. GBP underlying (top chart) and Skew vs. GBP underlying (bottom chart)

Digging into the CVOL for GBP in particular, I want to look at two different graphs. The top graph is the CVOL vs. the underlying for GBP. The pattern we see here is that while the underlying may be showing signs of basing and moving higher, the CVOL level is at the lows of the last year. This may be a good time to be long options. The second chart may be more telling. It shows the skew within CVOL, the relative preference for GBP upside (call) options vs. GBP downside (put) options. It is also compared to the underlying. Last fall and early this spring, you can see that the movement in skew gave us a leading indicator for what would happen in the underlying. Right now, the skew has moved higher, possibly foreshadowing a move higher in GBP that we have yet to see.

Image 9: Implied volatility by strike for August GBP options

While the skew is moving higher in GBP, if I look at the implied volatility by strike, I can still see that there is a preference for downside options. We see puts trade above the at-the-money options and that calls trade below the at-the-money options. This tells me there still may be an opportunity to not only lean long options, but to be a net buyer of call options and to use the put options as a source of funds.

Image 10: Expected return for a short August GBP 1.2550 put vs. a long 1.2850 call

Putting all of this together, I have come up with a trade idea to express my long GBP view vs. the USD. This view is predicated on the possibility of higher inflation, which we may be seeing in the commodity markets, especially the metals. Higher inflation benefits UK stocks relative to U.S. stocks, which could potentially see a rotation of capital into one market and out of another. Technically, GBP has been basing and has moved above the moving averages. The CVOL skew has been a good leading indicator of movement and is pointing to the possibility of an upside move. While skew has moved higher, we see that call options still trade at a discount to the at the money, while puts trade at a premium. 

I could choose to buy GBP futures as a way to express this view. However, I believe one may find a better expression by selling a 1.2500 put and using the proceeds to buy a 1.2850 call, both for August expiration. Choosing the August expiration, I will get another two months of inflation data. In addition, we will have two more meetings for each of the central banks. Since my technical view is longer term, it also gives me some time for the idea to play out. 

There is a risk when I sell puts as there is unlimited downside. However, when I buy futures there is also unlimited downside. Thus, my risk really is no more by using this structure. If GBP/USD stays in the 1.2400-1.2800 range it has been in this year, one can argue it is more than likely that both of these options would expire worthless. The benefit of this structure is that on the upside, I have positive exposure to the underlying via my call options and had no premium outlay to gain that exposure. If I thought CVOL or implied volatility would move higher, I could choose to do a ratio and buy more calls, taking on some premium risk to gain leverage to the move. For me, I am happy for now to do it one to one and have this as a more capital-efficient expression of my long GBP idea. 

Good luck trading!

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