The GBP/CAD currency pair, which expresses the value of the British pound sterling in terms of the Canadian dollar, has managed to continue to fend off long-term lows over the past few years. However, in spite of Brexit (the U.K.’s decision to leave the European Union, which was announced on 23 June 2016), GBP/CAD has in fact managed to continue to trade above the lows of 2010 to 2013.
The long-term monthly candlestick chart below illustrates price action from as early as January 1975. Two levels are highlighted: 1.60 and 1.50. GBP has managed to safely avoid the 1.50 handle since the announcement of Brexit, although current prices above the 1.70 handle are still a far cry from the highs above 2.00 in the latter half of 2015 (and early part of 2016).
(Source: TradingView. The same applies to all subsequent candlestick charts presented hereafter.)
If we focus on more recent years, since 2000, we can see that GBP/CAD has fallen from highs above 2.50 down to levels under 1.50, and yet in spite of this the 10-year yield spread (the blue line, in the chart below) is currently back to where it used to be at its high. Yet clearly prices are still languishing far below the highs above 2.50 (found in 2002, 2003 and 2004).
The 10-year yield spread rose fairly consistently from the year 2000 into mid-2008, yet GBP/CAD continued to trade through this period. The 2008/09 Great Recession saw markets continuing to prefer CAD over GBP, all the way into the exchange rate’s long-term lows under 1.50 (in 2010). Currently, the 10-year yield spread is once again negative (albeit above more recent lows in 2018).
The bond market’s 10-year yield spread is negative 35 basis points (pictured above, on the far-right y-axis). This compares to the difference between the short-term interest rates of the Bank of England (10 basis points) and the Bank of Canada (positive 25 basis points) of negative 15 basis points (i.e., 10 minus 25). I highlight these rates in the table below.
Therefore, the bond market is probably a little pessimistically priced at the moment in terms of GBP/CAD rates. Even if the Bank of England were to visit the “zero lower bound” (cutting rates by another 10 basis points), the 10-year yield spread would still be leaning on pessimism. Of course, the pessimism could turn out to be well-founded, but at this juncture, it is worth noting because it does mean that economic outperformance from the U.K. could send GBP/CAD significantly higher on the back of surprise.
A more recent chart reveals that GBP/CAD is, on a short-term basis, trading fairly consistently within a trading range. March 2020 saw a large expansion of this range, but the midpoint of 1.73 would basically remain even without this expansion. Current prices are close to the midpoint.
Remember that this pair is technically negative-carry, and so it is certainly not attractive from the perspective of interest rates.
In fact, even being short this pair is not attractive for similar reasons; interest rate spreads are too tight. Having said this, as of October 8, 2020, three-month GBP LIBOR is about 5.2 basis points positive, while three-month CAD CDOR is 50 basis points positive (as at the same date). Therefore, while official short-term rates imply a fairly tight spread, real funding markets are suggesting a relatively tight CAD and a loose GBP. This is confirmed by retail broker spreads (see below), which indicate an average spread of negative 66 basis points for GBP/CAD (one of the most negative spreads in major FX).
It is debatable whether or not this will persist, but at present, funding markets do seem to support a weaker GBP over CAD.
When interest rate differences are historically tight, it is also more important to look at inflation rate differentials. Lower inflation rates improve real yields, while higher inflation rates weaken real yields. In this case, we can look to how inflation has changed over time (for both the U.K. and Canada) since the start of 2020, and in relation to 2019 levels. Note also that the Bank of Canada’s short-term rate was +1.75% at the start of the year, while the Bank of England started at a lesser rate of +0.75%.
The U.K.’s inflation rate has fallen from 1.8% in January 2020 to just 0.2% in August 2020. As we can see, year-over-year inflation rates are falling fairly consistently, and the U.K. now faces the prospect of deflation unless inflation begins to pick up in the last quarter of 2020. The drop from 1.8% to 0.2% represents a change of 160 basis points.
(Source: Trading Economics)
Canada’s inflation rates, in contrast, have fallen from 2.4% in January 2020 to just 0.1% in August 2020 (the country also saw deflation in April and May, as shown in the chart below). The total change in this case is therefore a much larger 230 basis points.
(Source: Trading Economics)
The table below illustrates the change in real interest rates (using central bank rates, not rates from funding markets) from January 2020 to August 2020.
The real (i.e., inflation-adjusted) interest rate spread is calculated in the bottom table of the two tables shown above. This is the inflation-adjusted GBP rate minus the inflation-adjusted CAD rate, and the workings show that the real GBP/CAD spread has in fact improved by 15 basis points since the start of the year. The spread is still negative however, and the improvement does not map perfectly against what we see in funding markets.
The conclusion we could draw from this picture is that GBP/CAD is likely to trade close to the prevailing midpoint of 1.73, but probably preferring a tight range below this midpoint (between, say, 1.68 and 1.73). The negative spread should place downside pressure on the pair, but the otherwise tight spread (on the basis of central bank rates) and technically improved “real rate” differentials should together prevent significant downside.
Another long-term model, being Purchasing Power Parity, would suggest that GBP/CAD is currently most likely fairly priced (or perhaps only slightly undervalued). To construct the chart below, I use data from the OECD’s PPP model. Given that 2020 inflation rates between the U.K. and Canada are not significantly different, it is probable that the 2020 PPP-implied fair-value estimate will be similar to the 2019 estimate. The PPP model (illustrated below by the centered red line) has been rather stable for many years.
(Sources: Investing.com and OECD)
I also add upper and lower bands to the PPP model shown in the chart above, which represent deviations from the PPP fair-value estimate of 30% (either side). As we saw in the years between 2000 and 2007, GBP/CAD was technically significantly overvalued on the basis of relative purchasing power. This probably explains what we saw earlier, as in spite of the 10-year yield generally improving from 2000 through to mid-2008, this was not enough to support what was an already overvalued pair.
Since 2008, GBP/CAD has traded in a fairly disciplined way with respect to the PPP model. CAD possibly struggles to find sustained strength against GBP in light of Canada’s energy sector (which represents about 10% of GDP). After a series of oil price declines over the past decade, CAD is generally not considered to be a safe haven (on the contrary, it is considered a commodity currency owing to Canada’s exposure to crude oil prices via exports, and as a result, its positive correlation with oil prices). Yet risk and uncertainty are too high for the U.K., considering Brexit and the fact that its service-led economy has been hit relatively hard by the COVID-19 crisis this year.
Despite the risks that both the U.K. and Canada face, the risks are perhaps somewhat in balance; markets are not “preferring” either GBP or CAD. With 2020 year-end representing a hard deadline for the U.K. to either succeed or fail in securing a formal trade deal with the EU, it is possible that markets will lean on GBP/CAD weakness into year-end. The negative interest rate spread in funding markets would also help to support this move (enabling leveraged traders to profit from the positive carry of a short position).
However, given that GBP/CAD is already close to fair value (per our PPP model), and as funding markets may later adjust upward to better reflect central bank rates, downside may be limited. It is interesting that in mid-June earlier this year, the U.K. had the option of extending its year-end deadline but rejected this option. GBP initially traded lower, but was trading significantly higher into the latter part of July. To me, this might suggest “Brexit fatigue”, and that perhaps markets are no longer deeply concerned with the risks and uncertainties in relation to Brexit. After all, the decision was announced over four years ago now.
Should the U.K. fail to secure a trade deal, it is likely that GBP will trade lower in the short term, and that remains a risk. However, in the medium term that follows such a drop, it is possible that GBP will quickly find support and trade much higher (as we saw in June and July, for instance), provided that economic data does not worsen significantly as a tangible by-product of this no-deal scenario.
My outlook on GBP/CAD is mixed; in the short term, I think it offers potential for range-bound trading between 1.68 and 1.73 (lows and highs, respectively). Yet the pair also deserves monitoring, along with other GBP FX crosses, as there is potential building for a stronger GBP in Q1 2021 (even if the year begins with downside volatility in a no-deal scenario).
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.