• This model implies that the warranted rate of the GBP against the USD based on changes in interest rate differentials would be 1.539. This suggests that the current level of the pound—of 1.617—may be approximately 4.8% too high, given the changes in interest rates we have seen.
• What is most interesting about this regression analysis is that the current (10/16/2013) predicted value of the GBP vs. the USD (green line) deviates significantly from the actual value of the GBP vs. the USD (blue line). This 4.8% deviation is rare by historical standards and has occurred less than 10% of the time since 2008.
• One measure for how accurate these statistical models are is “goodness of fit,” as measured by the R-squared of the analysis. An R-squared of 0% suggests that the model is unable to explain the variability of the British pound based on the two-year interest rate differentials. An R-squared of 100%, on the other hand, suggests that the model is able to explain all of the variability of the British pound based on the two-year interest rate differentials. This particular model had an R-squared of 76.8%. For statistical analysis, this is a fairly high percentage.
In conclusion, economic theory and empirical evidence suggest that the British pound has room to depreciate against the U.S. dollar. While good economic data out of the UK has buoyed sentiment around the currency, disappointing economic data could trigger a sell-off, causing the currency to trade more in line with its interest rate differentials. For those who are allocating to United Kingdom equities, currency-hedged strategies can be an important tool.
1The interest rate differentials used were based on interest rate swaps. These are a highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount, from a fixed rate to a floating rate (or vice versa) or from one floating rate to another. An alternate measure of interest rate differentials are the respective government bond differentials, but they tend to have distant maturities and are subject mostly to sovereign related stresses.
Important Risks Related to this Article
Investments focused in the United Kingdom are increasing the impact of events and developments associated with the region, which can adversely affect performance. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations.