Sterling’s political risk premium disappears at the most curious moment

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This week Michael Metcalfe, head of Global Macro Strategy, asks whether the FX market has already cast its vote on the UK election.

 

“Thanks to the heavy weight of foreign earnings in the Financial Times Stock Exchange (FTSE), it is sterling that has served as the market bell-weather of UK political risk. Reflecting this, our valuation metrics, based on the purchasing power parity of a large basket of online prices collected by PriceStats*, suggest that the currency has been anywhere between five percent to 15 percent undervalued since the referendum. It is curious then, that on the eve of such a pivotal election, sterling’s valuation premium has disappeared against the US dollar and actually reversed against the Euro.

 

“The only way to explain this puzzle is the markets’ unencumbered confidence in the polls, as well as what will happen after. The surprises of the referendum and recent elections have been dismissed; a punchy call given there are more marginal seats today than two years ago. In addition, such a fair valuation for sterling also seems to imply a belief that Brexit will indeed get done, along with some kind of trade deal in 2020. All of that combined seems to price in a lot of certainty into what could still be very uncertain times, even if Thursday’s result did bring some temporary relief.”



*About State Street PriceStats®

PriceStats is a provider of high-frequency global inflation indices and purchasing power parities that offer insights into key macroeconomic variables. The indices are generated using software that scans the underlying code on public websites to capture the full array of products sold by online retailers, including food, beverages, electronics, apparel, furniture, household products, prescription drugs, and over-the-counter medicines. The technology monitors price fluctuations on roughly five million items sold by hundreds of online retailers in more than 70 countries. The PriceStats methodology is grounded in the extensive body of research of MIT professors Alberto Cavallo and Roberto Rigobon and their Billion Prices Project at MIT. Cavallo and Rigobon have leveraged this research and their expertise in monetary economics to develop the PriceStats indices.

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