Is the pound undervalued due to politics?

"Pound undervalued" has been a regular comment over the past few months as Sterling has seemingly free fallen. As any retail Forex trader knows, currencies are volatile, but major currencies tend to trade in a range rather than drop 20%+ in under 12months! Let's explore how this happened.

How did we get here?

On the 23rd June 2016 in the Brexit referendum, UK voters decided to leave the European union. Boris Johnson, who is now prime minister, was at the forefront of vote to leave the EU campaign. As a member of the conservative party which has long wanted an EU referendum, he was influential in the future performance of pound sterling. His support for leaving the EU meant that a high profile politician could drum up the support needed to win the vote. As a general rule of trade, free trade leads to wealth and trade barriers lead to a loss of growth. As a result of the Brexit vote, international investors immediately thought the UK would be worst off and started pulling their money out. This led to an immediate drop in the British Pound.

Historical ranges

Currency trading pairs move in ranges, especially when it concerns major currencies such as Pound Sterling. In our example we will use USD as the other currency. GBP USD is one of the most frequently traded currency pairs for beginners, as its lower volatility is a good form of protection if you get it badly wrong. Having said that, when GBP USD changes ranges, it can happen quickly and be rather large. These changes are a re-setting of the demand of each currency. Since 2009, Pound sterling has stayed close to the 1.50 range versus the USD, Having traded in the 1,8-1.9 range for the previous 3 years, Then came the Brexit vote. 

The day that Sterling did not stand still

Let's be clear, the Brexit vote was a  Forex news shock. Many did not expect it and even fewer were positioned for it. In general, if the market prices in a surprising event, it barely moves if this event comes to pass. If, on the other hand, it does not expect the event, it has to re-adjust its pricing now that new information is available. This is where the large moves happen. In the days following the Brexit vote, this is exactly that happened to Sterling, as traders and investors adjusted their positions. Sterling promptly started to slide eventually reaching close to the 1.20 level versus the Dollar, which it tried to break but eventually bounced back from. A smart trader would of protected themselves from such an event by using stop losses or using the risk reward ratio.

Cometh the hour cometh the man

When Boris Johnson was elected by members of the conservative party to be their leader, he was seen as having the gravitas (not in all quarters it has to be said) to lead a government strong enough to actually run the country. With a strong(er) government (than the previous regime), the pound started to recover as a result of investors seeing the UK having some form of direction. At the time of writing, pound sterling as got to 1.31 versus the USD. Takeovers of UK listed firms has also created a demand for sterling which had not been there before.

Confidence is key

Although it is pushing it to say that this latest prime minister has created renewed confidence in sterling,  confidence has returned in Sterling. This latest prime minister has faced the same problems as the previous one, but has managed to create a momentum through increased confidence in his government. Forex markets are like any publicly listed market, confidence leads to people investing, and momentum creates a direction that other traders can buy into (going long), or position themselves against (going short).

Is the pound undervalued today?

With the pound hovering around 1.31 but having traded as high as 1.90 not so long ago versus the US dollar,  it is still possible to argue that pound undervalued is still worth a trade. Yet with a general election around the corner and a leader of the opposition who has managed to engage the younger generations more than ever, who is certain what this means for Sterling? Jeremy Corbyn's ideas around nationalisation are seen as anti-business. If he was to be elected or if Boris Johnston did not get a strong enough majority, Sterling's recent strength would likely suffer.

Conclusion

After such an unexpected event, it is unsurprising this has led to decreased investment in the UK. UK companies are delaying investment and foreign companies are choosing to invest elsewhere, as a result it is normal that the pound has become undervalued. Quite simply, if you're not popular, you're not valued... and few foreign investors has been keen on the UK, let alone investing in it over the past few years.