Excell with Options: Inflationary pressures on GBP vs USD FX futures
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.