The Challenge of Sterling

Many participants can single out a currency that is particularly vexing for them. Some say that the yen is the graveyard of all good (and poor) traders. Yet for many currency pairs there are some factors that seem to be more influential than others, even if over time, there is significant variability. For example, the two-year interest rate differential between the US and Japan on one hand and the dollar-yen on the other.

In this sense, sterling is especially challenging. It relationship to equity markets and interest rate differentials tends not to be very strong. It is difficult to know what to look at for clues into sterling's direction.

Around the same time the euro's correlation (60-day percentage change) with the S&P 500 put in what appears to be a record high in early December near 0.85, sterling's correlation set its record high near 0.72. The correlation now stands near 0.50, while the euro's is near 0.45.

While interest rate differentials often seem to impact the dollar-yen and euro-dollar exchange rates, sterling's relationship with interest rate differentials seem less clear. Here because of the distortion of taking the percent change of a percent, we look at simply the level of the rate differential and currency rate to conduct the correlations.

The dollar rises against the yen as the 2-year interest rate differential widens (0.95 presently). Recently the euro and the 2-year US-German spread has became positive correlated (rate differentials widen in US favor and euro strengthens), for only the third period since the fall of Lehman and after a 0.90 inverse correlation as recently as mid-January. As of now the correlation is beginning to become inverted again.

Sterling is presently inversely correlated with the 2-year interest rate differential (US-UK). Since Lehman's failure, sterling's correlation with the 2-year spread has been as high as 0.80, which was approached at the start of the year and during periods of inversion, the has mostly bottomed around -0.40. It currently stands at -0.34. There are many more periods of inversion than the euro showed. The correlation with the 10-year spreads is no more informative.

We have looked at sterling's correlation with oil and also did not find anything interesting either. Finding so many seeming dead end, we find that returning to basics may be the best. The most basic consideration is that sterling is a low beta form of the euro. Sterling's correlation (60 day percent change) with the euro has largely been confined to 0.5-0.7 since Lehman's fall. It is currently at 0.67. The 3-month sterling implied vol is 2.5 percentage points lower than the euro's implied vol.

This is can be important for portfolio construction. For shorter-term market participants considering sterling as a low beta euro means that in a weak US dollar environment the euro is likely to gain on sterling and in a strong dollar environment sterling is likely to outperform the euro.