(Bloomberg) -- The market’s confidence in the pound is shattering after a world-beating run.
Traders are now pricing a faster pace of monetary easing, diminishing the allure of the strongest-performing currency among Group-of-10 nations so far in 2024. Some, including Millennium Global Investments, see it sliding as much as 10% over the medium term.
All it took was a few phrases from Bank of England Governor Andrew Bailey.
The BOE could become a “bit more aggressive” and “a bit more activist” in its approach to cutting rates, he told the Guardian newspaper last week. By Friday, the currency had clocked its biggest weekly loss since February last year.
“This could be a turning point for the pound,” said Nick Andrews, senior FX strategist at HSBC Holdings Plc. Bailey’s remarks were “deliberate” and “meaningful,” he said.
For months, investors have been plowing into sterling on expectations slower easing by the Bank of England relative to other central banks would preserve the currency’s high-yielding status.
A surprisingly large rate cut by the Federal Reserve last month only cemented the view, and drove the pound as high as $1.3434, its strongest level since February 2022.
But now options contracts show traders are paying up to protect themselves against a fall for sterling. So-called risk reversals, also often used as a barometer of sentiment, have fallen to their lowest in nearly two months, following a sharp drop over the past week.
That suggests further pain ahead for investors that have crowded into bets on pound strength in recent weeks. Bullish wagers by hedge funds and other leveraged funds are around their highest in six years, and those accounts again boosted wagers on the pound ahead of Bailey’s comments, according to data from the Commodity Futures Trading Commission.
Downward Momentum
“When you have such stretched positioning, it always raises the risk that you get a sharp repricing as the market’s expectations for rate cuts changes,” HSBC’s Andrews said. “I expect the downward momentum behind a lower sterling will build, and some of these long sterling positions to be taken out.”
Rates markets are pricing an almost quarter-point cut at the BOE’s next meeting in November. Between then and the end of 2025, they are betting on a total of 127 basis points of easing, while HSBC envisages much more aggressive moves of 225 basis points for that period.
A key test for the currency is approaching later this month, when UK Chancellor Rachel Reeves announces a budget expected to contain tax hikes and austerity measures, which could crimp growth in the coming years.
“It’s surprising that the British pound remains so strong,” said Pierre Lequeux, head of investments at $26 billion currency manager Millennium Global Investments. “Markets are underestimating fiscal risks to UK growth and domestic consumption ahead of the October budget.”
Lequeux sees the currency closer to $1.20 over the medium term, a drop of almost 10%.
Some aren’t convinced, arguing that political stability is spurring demand for UK assets, which will continue to support the pound in the coming months.
The latest selloff “may be overdone,” said Jane Foley, head of FX strategy at Rabobank. She sees the pound bouncing back to end the year at $1.34, while trading at 0.84 versus the euro.
“UK inflation risks still suggest that the BOE could be slower to cut rates than several of its peers,” she wrote in a note.
Echoes of 2018
But others see warning signs in the recent past.
The current scenario is reminiscent of early 2018, the last time investor positioning piled up so strongly in favor of the pound.
At the time, a warning from then-BOE Governor Mark Carney that slowing growth could delay the start to rate hikes triggered a selloff. As the bullish bets were unwound, the currency sank about 12% versus the dollar in the ensuing months.
According to Jordan Rochester, head of macro strategy at Mizuho International, a replay is possible.
“It’s like when Carney said in 2018 that GDP could come in weak, and if so, they may need to slow the pace of rate hikes,” he said. “Bailey’s just done the same, but in the opposite direction.”
“Even if the selling this time isn’t as extreme as that move, we could still see a fall or around 5% or so,” Rochester added. “The risk reward is quite clear to me. I’m not sure what the upside is.”
--With assistance from Alice Atkins.
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