The resilience of the pound amid geopolitical turmoil confuses the market

Investing.com - Bank of America notes that during recent geopolitical uncertainties, the British pound has shown unexpected strength, becoming the second-best performing currency against the US dollar since early March.

Given the challenges faced by the UK economy this year, the pound’s resilience is puzzling. Bank of America analysts believe that the pound’s performance is mainly due to favorable changes in trade conditions and position adjustments, rather than strong fundamentals.

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The bank states that GBP/USD has undergone a significant shift in mechanism. Over the past 20 years, this currency pair has been closely linked to Bank of America’s GBP risk sentiment indicator, which combines the first principal component of GBP risk premium, forex volatility, UK term premium, and the UK-US interest rate differential.

This relationship broke down in mid-2024, after which GBP/USD continued to deviate from the underlying GBP risk sentiment.

The current geopolitical shocks are global rather than UK-specific, pushing domestic concerns to the background. This marks a departure from earlier this year when EUR/GBP was the preferred currency pair to express concerns over UK domestic policy uncertainty.

Bank of America has identified two key factors supporting the pound. First, compared to other G10 currencies, the UK has experienced a relatively favorable shift in trade conditions, forcing position squeezes.

Analysis shows that changes in trade conditions and position standard deviation have driven the pound’s performance over the past few weeks.

Second, energy sector capital flows have provided support. According to Michael Hartnett of Bank of America, energy stocks recorded the largest net inflow on record.

The UK stock market ranks third among developed markets in energy stock concentration, and the strong performance of the FTSE indicates significant capital inflows into this sector.

Although the UK remains heavily dependent on energy imports, this dependency is lower than in Japan, the Eurozone, and Sweden. This suggests a positive shift in trade conditions relative to EUR, JPY, and SEK.

Bank of America’s analysis shows that the pound exhibits persistent negative risk sensitivity. A typical one standard deviation increase in VVIX correlates with about a 5.43 basis point daily decline in the trade-weighted GBP index, with forex volatility at 3.49 basis points and bond volatility at 2.73 basis points.

Volatility remains relatively moderate, allowing position-driven adjustments to dominate the pound. However, Bank of America warns that a sharp spike in volatility could weaken the pound through traditional channels, given its high-beta, pro-cyclical nature.

As focus shifts to the Middle East, domestic UK issues have taken a backseat. However, with less than two months until the May local elections, Bank of America believes the market is underestimating the potential for domestic political uncertainty to rise again. Its analysis shows that two-month foreign exchange options now price in the election date.

Bank of America recommends clients hedge against a recent rebound in the pound, especially against the euro, to prepare for possible reversals before May. The bank states that current volatility levels appear cheap.

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