The GBP/USD currency pair, which expresses the value of the British pound sterling in terms of the U.S. dollar, has pushed higher since the latter half of July this year. Yet in recent weeks, GBP has struggled to sustain its advance against USD. The chart below uses weekly candlesticks to illustrate GBP/USD price action from around 2017 through to present.

(Source: Trading View.)

The U.S. dollar has sold off against various currencies, including perhaps most notably the euro, as markets have become less convinced of the world reserve currency's entitlement to a premium. The surprises which occurred in the first half of this year, which arose due to the COVID-19 crisis, have been addressed through significant fiscal and monetary policy interventions. Governments continue to intervene, yet the demand for USD has seemed to dry up relative to the first half of the year. The U.S. Federal Reserve's FX swap lines have fallen substantially in demand, from a peak of around $450 billion (from foreign central banks) in May, down to approximately $100 billion.

USD is viewed as a safe haven and often rallies during market turmoil. With equities now back at all-time highs, risk sentiment is positive and interest rates are now extremely low (the U.S. short-term rate has been crushed this year, falling to the zero lower bound of 0.00-0.25%). Therefore, there is little safe-haven demand for USD, and very little appeal to buy USD on the basis of any interest-rate spread. Liquidity remains high and yet USD still remains overvalued on the basis of its international purchasing power.

This overvaluation has been made worse this year, as the United States' terms of trade (the ratio between its export and import prices) has worsened (importantly more than major European nations such as Germany). The chart below shows the collapse in the U.S.'s terms of trade this year, while Germany (in this case perhaps serving as a proxy for the euro) has had a better year thus far (as at the end of Q2 2020).

(Source: Trading Economics.)

A country's terms of trade is one factor, but a factor with greater overall importance is purchasing power parity (the relative purchasing power of a currency internationally). As presented in a recent article of mine, EUR/GBP seems to offer further upside on the basis of a PPP model which uses OECD data. Below, I construct a simple PPP model (the "step-function" red line, which is up-to-date through 2019) using the same OECD data set, alongside GBP/USD prices (the black line). GBP/USD is still technically undervalued.

(Data sourced from OECD and Investing.com.)

Rather nicely, the 2008/09 Great Recession saw the GBP/USD significantly through to the PPP model's implied fair value. In other words, prior to this crisis, it would seem that (on the basis of international trade and relative purchasing power) GBP was already significantly overvalued. The run on USD, driven in great part by safe-haven flows, crushed GBP/USD with rapidity. GBP then rebounded but remained fairly range-bound between 1.40 to 1.70 through to the announcement of Brexit, which has meant that GBP has been trading at a discount ever since.

This long-term pessimism means that one day, GBP/USD could enjoy significant upside, at least through to 1.40 (relative to the current market price of around 1.30), and perhaps through to the previous range of around 1.40 to 1.70. The running premium (discount) rate (comparing the prevailing market price to the PPP-inspired fair value estimate) is shown below (using the same data as used in the chart above).

However, risks remain. As I noted in my article covering EUR/GBP, the deadline for a trade deal between the U.K. and the EU is the end of the year. Prime Minister of the United Kingdom Boris Johnson did not exploit the opportunity to extend the deadline by the end of June 2020, and therefore the U.K. now faces the very real possibility of crashing out of Europe's free trade area into 2021. This was arguably imprudent of Johnson, considering that the country also currently faces an unprecedented pandemic-driven economic crisis. The chips will fall as they may, but one would think that this risk will weigh on GBP. Until at least the end of 2020, we should look at any economic data this year (from the United Kingdom, and perhaps indeed from any country) with skepticism.

Taking a broad perspective, it does not make sense for GBP to trade at a premium to USD. Therefore, we should not be surprised that it trades at a discount (if not "fair value"). GBP has traded in a volatile fashion this year, much like a commodity currency, and this makes sense given that GBP FX liquidity has dropped significantly. The U.K. is now effectively "on its own" following Brexit, and no longer enjoys the security of being part of the European Union. Whether or not Brexit was a good decision for the country is debatable, but it is arguably quite clear that it does not place the British economy in an enviable position in the near term.

The euro is rising against both USD and GBP for EUR-specific reasons: as noted in my EUR/GBP article, given the pandemic and joint issuance of sovereign debt, there is potential for higher European bond yields and reduced E.U. break-up risk. Furthermore, USD seems to continue to hold a premium over certain currencies including the euro. Therefore, there is still further room for the euro to ascend versus USD, while GBP-specific risks continue to hold given Brexit.

Until year-end, I believe that EUR/USD could continue to remain firm, yet we have to ask ourselves why USD has been falling. It has held a premium over EUR and other currencies, while safe-haven demand (in the FX space) has dried up, and the U.S. economy has not been a net-beneficiary of net movements in import and export prices. Yet while the U.K. has likely benefited in part by the pick-up in global risk sentiment, the economy is smaller than the United States's economy, and immediate Brexit risks hardly make GBP an attractive alternative to USD (especially given GBP's reduced liquidity, which is a sign of reduced international trade and investor demand).

Note that should the U.K. drop out of the EU without a formal trade deal in place, this could cause significant supply chain issues as trade between the U.K. and other countries could suffer certain frictions that it has not heretofore (including tariffs) should the U.K. fall back on standard WTO trade terms. GBP is likely to remain subdued because of this; buyers are likely to be less interested (on average) in establishing significant and/or long-term relationships with U.K. exporters until greater certainty is achieved, which essentially drops the appeal of the potential arbitrage in the GBP-USD discount (with respect to our PPP model).

I continue to believe that GBP could surge to the upside in the long-term future, perhaps even at some point in 2021, especially if a trade deal can be achieved with the EU (even if it has to occur past the 2020 year-end deadline). But for now, GBP does not appear to be an attractive alternative to USD, and I believe GBP (independent of risk sentiment) deserves to trade at a discount until greater certainty and longevity can be achieved and assured. Since the Bank of England's short-term rate is just +10 basis points, effectively lower than the U.S. Federal Reserve's target-rate midpoint of +12.5 basis points, there is also zero carry-trade appeal in GBP/USD.

Speculators (based on the CFTC's weekly report of U.S. futures markets) also seem to be neutral on GBP. With little reason for late-2020 optimism, at least at this current juncture, I believe the next most appropriate direction for speculators will be to bet against the currency through year-end. GBP is worth monitoring, but I continue to believe downside pressure is more likely to be found in the near term (at least to the 1.27 handle).

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.

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GBP/USD Struggles To Break Higher As Brexit Risks Remain, While USD Appears Safer - Seeking Alpha