Strategy January 23, 2019 / 03:00 pm UTC

Political Risk Premium in EURGBP Overstated

By Adrian Schmidt

Bottom line: Don’t be deceived—simple yield spread correlations vastly exaggerate the likely scope for a GBP rally on a favorable Brexit deal. 

Figure 1: GBP Undervalued vs. EUR Using Nominal Yield Spreads?

Source: Continuum Economics

The Illusion of a Risk Premium

Many in FX markets are suggesting that there could be a lot of upside for GBP in the event of a positive Brexit outcome, which would involve either a soft version of Brexit, probably encompassing staying in the Customs Union, or possibly no Brexit at all. This idea depends on the assumption that there is some sort of political risk premium currently inherent in GBP—charts like Figure 1 have been used to illustrate this.

It’s All Relative

The problem with this idea is that it ignores the issue of actual and relative inflation. EURGBP is trading at 0.88, but 0.88 now is not the same as 0.88 in 2009. Since then, the UK has seen much higher inflation than the Eurozone (EZ), both in consumer price and producer price terms. As a result, GBP is, in real terms, effectively much higher and thus less competitive. 

Furthermore, nominal yields in the UK are higher than they are in the EU, and particularly the EU core. However, this is not the case in real terms because of the combination of relatively high inflation in the UK, juxtaposed with persistently low inflation in the EZ. When we adjust the currency for the relative rise in the UK price level over time and 10-year yields for the relatively high level of UK inflation (using a 2-year average), we get a different version of the GBP/yield spread (Figure 2).

Figure 2: Tighter GBP/Yield Spread in Real Terms

Source: Continuum Economics 

Real Rates Offer the Real Story

While there may still be a modest political risk premium in GBP, it is nothing like as large as the nominal chart suggests. This is important because if a positive Brexit agreement is reached, the benefits for GBP will probably be quite modest, and would be unlikely to undermine the attraction of UK equities, which remain very cheap by international standards and look attractive as long as a “no deal” Brexit is avoided. 

Of course, even if there is what looks like a favorable or “soft” Brexit agreement, this is also unlikely to be the end of the story. There will still be a lot of uncertainty about the eventual shape of any trade agreement with the EU, and the political repercussions of reaching a deal could further polarize both Parliament and the electorate. So, a solution is unlikely to eliminate political risk. And if, as the real data suggests, the political risk premium embedded in GBP is in any case quite modest, the upside scope for GBP on any deal looks quite limited.

4Cast Ltd. and all of its affiliates (Continuum Economics) do not conduct “investment research” as defined in the FCA Conduct of Business Sourcebook (COBS) section 12 nor do they provide “advice about securities” as defined in the Regulation of Investment Advisors by the U.S. SEC. Continuum Economics is not regulated by the SEC or by the FCA or by any other regulatory body. This research report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. Nonetheless, Continuum Economics has an internal policy that prohibits “front-running” and that is designed to minimize the risk of receiving or misusing confidential or potentially material non-public information. The views and conclusions expressed here may be changed without notice. Continuum Economics, its partners and employees make no representation about the completeness or accuracy of the data, calculations, information or opinions contained in this report. This report may not be copied, redistributed or reproduced in part or whole without Continuum Economics’s express permission. Information contained in this report or relied upon in its construction may previously have been disclosed under a consulting agreement with one or more clients. The prices of securities referred to in the report may rise or fall and past performance and forecasts should not be treated as a reliable indicator of future performance or results. This report is not directed to you if Continuum Economics is barred from doing so in your jurisdiction. Nor is it an offer or solicitation to buy or sell securities or to enter into any investment transaction or use any investment service.
Analyst Certification
I, Adrian Schmidt, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.