Potential Sterling Slippage Spotlights These ETFs

The British pound has been one of the top-performing developed market currencies for about a year, a fact affirmed by the 8.3% returned by the CurrencyShares British Pound Sterling Trust (NYSEArca: FXB) over the past 12 months.

On Wednesday, FXB gained a third of a percent, rising to its highest levels since October 2008, but much like the euro, there are plenty of market observers that view sterling as overvalued. [WisdomTree: How a Strong Euro Affects Equity Allocations]

“We expect GBP to decline from current elevated levels against the USD. All the good news appears to be priced in, with GBP not being able to break out to the upside of current range, even though retail sales and GDP showed that the UK economic recovery remains robust,” said ETF Securities Research Director Martin Arnold in a note out Wednesday.

At this writing, GBP/USD trades around 1.6880, an area where further upside from there could be limited.

“Gains appear capped above 1.68 level against the USD after the modest inversion of interest rates in favour of the US. With volatility approaching the lowest levels in six years, we expect there to be limited room for further decline in volatility and as such could be approaching a critical breakout point for GBP. Volatility and GBP/USD direction are negatively correlated, so any economic surprises could see volatility move back toward longer term average levels, in turn prompting a sharp move lower in GBP/USD,” said Arnold.

Should British equities remain sturdy in the face of a potential pound pullback, two ETFs merit attention: The WisdomTree United Kingdom Hedged Equity Fund (NasdaqGM: DXPS) and the db X-Trackers MSCI United Kingdom Hedged Equity Fund (NYSEArca: DBUK), both of which hedge GBP/USD exposure. [Don’t Forget These Currency Hedged ETFs]

At the sector level, both ETFs offer positive attributes, namely an average allocation of 17.9% to the energy sector. With U.K.-focused ETFs, that means large weights to Royal Dutch Shell (NYSE: RDS-A) and BP (NYSE: BP). Those stocks combine for about 16% of DXPS, an ETF that debuted last June.

DBUK has a combined 14% weight to those stocks, but the ETF features a modest allocation to Tullow Oil, one of the hidden gems among U.K. oil companies. Either way, the energy weights in DBUK and DXPS are significant at a time when the sector is outperforming and international oil stocks are keeping pace with, and in some cases, topping their U.S. rivals. [Global Energy ETFs Soar]

The aforementioned interest rate differential is another catalyst that could lead to near-term pound weakness and upside for DXPS and DBUK.

“The trend in interest rate movements in the United States and the United Kingdom suggests that recent strength in the British pound (GBP) cannot be explained by the change in interest rates and thus may be considered unwarranted,” said WisdomTree Research Director Jeremy Schwartz in a note published in November 2013.