(Bloomberg) -- The pound’s peer-beating rally got a fresh spur this week, but strategists from J.P. Morgan Private Bank, State Street Global Markets and Jefferies say those gains are looking increasingly fragile.
The Bank of England’s decision to hold interest rates on Thursday after the Federal Reserve delivered a jumbo cut the day before has lifted sterling to its highest since March 2022 versus the greenback. The pound is the best-performer in the Group-of-10 nations this year by a long stretch, with bets for further strength near the highest in a decade.
But a flagging UK growth spurt in the first half and a belt-tightening Labour budget in the cards for October mean there are clouds ahead — increasing the chances the BOE needs to ratchet up the pace of rate reductions to shield the economy, while removing a key pillar of support for the pound.
“I think the pound-dollar pair is living on borrowed time,” said Tim Graf, head of EMEA macro strategy at State Street. “Ultimately, I think the pound will be lower against the dollar in three to six months’ time.”
And while other central banks ramp up their pace of easing, the BOE’s gradual approach to cuts means the pound has become a crowded destination for investors looking to capture higher relative returns.
Bets held by hedge funds and other leveraged funds in favor of the pound are hovering near their highest levels since 2014, after surging in July, according to positioning data from the CFTC. In the past month, institutional investors have become the most bullish on the pound in a year.
Sterling was trading around $1.33 on Friday, but HSBC Holdings Plc analysts called that kind of strength “unsustainable.”
According to Nick Andrews, a senior currency strategist at HSBC, 225 basis points of BOE cuts are needed by the end of 2025, compared with 150 basis points priced by markets. The pound will be challenged as investors gradually reconfigure their expectations toward deeper cuts, he said.
While the current, slower pace of UK rate reductions compared with the US makes the pound a prime choice for investors hunting loftier yields, there’s “little sense to chase these moves higher over the near-term,” said Matthew Landon, global market strategist at J.P. Morgan Private Bank.
To be sure, so-called risk reversals — a barometer of market positioning and options sentiment — show the market is favoring the pound over the next month, even as the trade becomes even more crowded. Traders say there’s continued demand for UK assets after the change of government.
What Bloomberg Strategists Say...
“More often than not, convergence in the spot and options markets suggests the prevailing trend has legs. Until the market changes course, or at least divergence emerges amid spot and options traders, UK assets should see further demand. When flows talk, it’s better to respect the price action, no matter how crowded a trade is.”
-Vassilis Karamanis, FX strategist. For more, click here
But longer-term, there could be trouble.
As the UK currency approaches its strongest level in two years against the euro, hedge funds have been buying protection against further strength in the options market, according to currency traders familiar with the transactions, who asked not to be identified because they aren’t authorized to speak publicly.
Against the dollar, the pound is already trading around 2.5% above $1.30 — the level strategists in a Bloomberg poll saw it ending the year. While a further rise to $1.35 in the coming weeks is possible, Brad Bechtel, global head of foreign exchange at Jefferies in New York, said he’s “cautious” about a push higher.
“There may be a little upside left on the pound versus the dollar, but not too much,” Bechtel said.
The tax hikes and spending cuts predicted for what some are calling the UK’s “austerity budget” next month won’t help the economy in the short term, either.
Stephen Jen, chief executive officer at Eurizon SLJ Capital, says it could prompt the BOE to accelerate its rate cuts to cushion the demand shock, while hurting the pound.
--With assistance from Anchalee Worrachate and Vassilis Karamanis.
(Updates with HSBC comment from seventh paragraph.)
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