The GBP/CHF currency pair, which expresses the value of the British pound sterling in terms of the Swiss franc, is continuing to languish around all-time lows in October 2020. The current exchange rate of circa 1.18 compares with all-time highs in Q1 2000 of over 2.70.
Since around 1994, while EUR/USD has established a wide historical range, EUR and USD have perhaps surprisingly both retained a similar degree of strength internationally over the long term. CHF, on the other hand, has outperformed both of these currencies, while EUR and USD have both outperformed GBP. This has resulted in GBP/CHF being one of the worst performers of all FX pairs across G10 foreign exchange.
(Source: TradingView. The same applies to price charts presented hereafter.)
Paying more attention to this year, in which we have seen GBP become ever closer to the United Kingdom’s year-end deadline to formalize a trade deal with the European Union, GBP has continued its downward trajectory. This Brexit background also coincides with the emergence and after-effects of COVID-19, a pandemic which has erupted and spread across the world, resulting in significant government interventions. Businesses have been locked down and shut down. Consumers have stayed inside. Oil prices have declined while equity prices have, following a crash, managed to reassert themselves on the back of significant global interest rate cuts and monetary stimulus.
GBP/CHF does, however, continue to languish, as CHF remains in high demand while GBP still appears comparatively risky. Yet the latter point is only partly true; while I contest it is true that GBP is trading in a sanguine fashion (perhaps ripe for a correction into year-end), the British currency is still managing to hold its own against USD. GBP/USD started the year just above the 1.30 handle, and currently trades above the 1.29 handle. In spite of a rush on the U.S. dollar which sent GBP/USD down in a flash crash (in March 2020) to as low as the 1.14 handle, the pair is basically unchanged on the year.
EUR/GBP meanwhile does remain elevated, and yet since USD has weakened against EUR this year, this is also arguably about a weaker USD. We have effectively seen a EUR and USD rebalancing this year; these currencies are the two most important world reserve currencies, and EUR has found greater demand after the short-term U.S. target rate dropped to the zero lower bound (between 0.00 and 0.25%) this year. In summary, perhaps to measure GBP sentiment it is better to look at CHF and JPY, both traditional safe havens.
The black line in the chart above presents GBP/CHF. The green line represents GBP/JPY. Both GBP/CHF and GBP/JPY have traded in a similar fashion, revealing weaker GBP sentiment this year. Even as U.S. equities have climbed back to achieve all-time highs following the crash in February and March 2020, these GBP crosses indicate that the British pound sterling is not in wide demand at present. Given the risks of Brexit, especially in this kind of uncertain macroeconomic environment, this makes rational sense.
Sentiment and confidence are important, perhaps more important than any other factor for currencies; confidence is what guides international capital flows, which is what moves currency values. Yet another important factor is the relative purchasing power of currencies, for which we can look to Purchasing Power Parity. The chart below I constructed using both price data and the OECD’s PPP model data. The chart reveals that GBP/CHF is trading at rather low levels in relation to its PPP-implied fair value.
The red line (in the center) in the chart above indicates the rolling annual fair value estimate based on PPP. The lower and upper bands represent levels that are 30% away from the fair value estimate each year. The most recent estimate is for 2019. If we assume not too much change in 2020, GBP/CHF would appear undervalued, even judging by history. Only in 2011 (since 2000, at least) has GBP/CHF dipped significantly lower relative to the PPP estimate.
GBP/CHF was relatively stable from 2012 to 2015. However, in January 2015, the Swiss National Bank abandoned its EUR/CHF peg, which previously artificially propped up the value of EUR/CHF (at circa 1.20, before the peg was dropped). EUR/CHF moved lower to circa 1.00 (parity) in January 2015, after the SNB made its announcement. The SNB then dropped its short-term interest rate to -0.75% (from zero, previously). In effect, the SNB swapped its large, artificial CHF liquidity provisions for incredibly low interest rates instead.
GBP/CHF strengthened immediately, alongside EUR/CHF. The two pairs then retraced their steps, but in the long term, both GBP and EUR have surprisingly continued to fall as CHF demand has remained high for years. This year has seen a continuation of the same, helped in the case of GBP by even lower interest rates (the Bank of England’s rate has dropped from 0.75% to just 0.10% this year, while one-, two- and five-year gilts yield less than zero at the time of writing).
Focusing on this year, we can look to the inflation rates of the United Kingdom and Switzerland, to adjust the short-term rates of these countries’ central banks (proxies for FX yields) for inflation. The table below summarizes the findings.
The implied real yield for GBP/CHF has therefore, since the start of year, worsened only slightly. While GBP rates have collapsed, the SNB’s rate is unchanged on the year. GBP inflation rates have also declined measurably, which has helped to buffer the loss of the implied nominal yield (although CHF inflation has also dipped firmly into negative territory this year).
All considered, rates are unlikely to be hiked in either country for a long while, and therefore GBP deserves to trade from a weaker base this year, as inflation is much more likely to return to the U.K. than Switzerland (judging from history, and the fact that even this year the U.K. has been able to stave off deflation, at least so far).
As we head into year-end, GBP still looks risky in light of Brexit, while safe havens like CHF look appealing, especially in light of the high macroeconomic uncertainty and the second wave of COVID-19 which remains a latent threat as we head into the winter months. Nevertheless, the prospect of a stronger GBP/CHF becomes an interesting prospect for 2021 and beyond, judging from the pair’s PPP value. A catalyst will be needed to change the direction, which might include a combination of the start of a new, robust business cycle (an economic boom) and heavier SNB intervention. Whatever happens, GBP/CHF is probably a pair to watch over the long term.
As I noted in a recent article covering AUD/CHF, I do see the potential for this pair to exhibit the “J-curve” effect; perhaps weak or modest price action over the next few weeks and months, but carrying latent upside potential that is ultimately released when uncertainty is unwound and the global economic picture becomes perceivably more accommodative to spending and investment. It is precisely this kind of economy (“safer”, more predictable) that the primarily service-led U.K. economy needs to perform well.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.