Author: Naomi Rovnick
LONDON (Reuters) – Sterling hit its highest level in about 2-1/2 years against the dollar and is still rising against the euro, with analysts warning the moves are being fueled by speculative interest rate bets that could quickly unravel in markets still reeling from the turmoil of early August.
At around $1.32, the British pound rose above most analysts’ target prices for this year, a stunning rebound after falling to record lows near $1.03 following former British Prime Minister Liz Truss’s September 2022 mini-budget.
Analysts and currency dealers say the Bank of England’s forecasts assume interest rates will remain high for longer than in the United States and the eurozone, which explains the rise but also makes the pound vulnerable to fluctuations if monetary policy forecasts change.
“Over time we will see deviations in (forecasts of) paths to price easing, which should lead to increased volatility,” said Nick Rees, senior market analyst at Monex Europe.
He added that the current value of sterling reflects expected economic growth in the UK but does not take into account the risk that the BoE will cut interest rates faster than markets currently anticipate.
Traders are predicting that UK interest rates will be higher than US rates in a year. The BoE cut rates by 25 basis points on 1 August to 5%, and money markets are pricing in a further 40 basis points of cuts by the end of the year. The European Central Bank is expected to cut rates by 65 basis points to 3% over the same period.
CONTINUE BUYING?
Traders are wary of a sudden sell-off in higher-yielding currencies after an estimated $250 billion in carry trades this month, in which speculators borrowed Japanese yen to buy higher-yielding assets.
The massive withdrawal of yen-funded positions just a few weeks ago has driven losses across higher-yielding currencies from the Mexican peso to the , boosting sterling’s popularity as a carry trade vehicle.
Marketing materials show that at least three major investment banks are recommending deals involving the apply of the currently faint but often unpredictable Swiss franc as a financing instrument for buying sterling.
“It’s pennies before a steamroller,” said Jonas Goltermann, head of foreign exchange at Capital Economics, referring to investments that can generate tiny, steady gains but come with the risk of sudden, catastrophic losses.
Debt-financed carry trades tend to thrive when markets are tranquil, but can quickly run into trouble when markets become volatile or interest rate expectations change.
Speculative investors using borrowed funds have dominated bets on the pound appreciating against the dollar for more than a year, with the transactions currently worth $3.5 billion, according to UBS futures analysis.
The same data shows that leading asset managers hold net tiny positions worth $700 million, suggesting that these long-term investors have an overall negative view of sterling.
BETS PLACED
Sterling has strengthened against the euro by almost 3% year-on-year and is the best-performing major currency against the dollar, up 4%.
They were boosted by hopes for improved political stability in the UK following Labour’s election victory in July, and for the economy to rebound from a minor recession in 2023.
Still, the modern government’s first budget, due in October, carries the risk of spending cuts or tax rises that could keep Britain’s high national debt under control but could hurt economic growth.
“All the good news for the pound is now priced in and there is clearly no bad news,” Goltermann said.
Rob Wood, chief UK economist at Pantheon Macroeconomics, said the BoE’s continued high interest rates could weaken the economy in the coming years, potentially weakening the pound.
ANGULAR
Shahab Jalinoos, head of G10 currency strategy at UBS, said there was still tension in currency markets following the yen shock in early August, and that stress could deepen as the U.S. presidential election approaches in November.
He added that carry trades tend to work when markets are serene, making the pound vulnerable to future volatility.
“But the position is not so large as to rule out the possibility of the pound recovering once the dust settles again.”
Monex’s Rees said the pound’s performance against the dollar was also likely to have been affected by faint demand over the summer.
The Bank for International Settlements warned this week that while there is no turbulence in currency markets at the moment, gigantic positions built up during tranquil periods could be quickly reduced when volatility increases.
Societe Generale (OTC:) chief currency strategist Kit Juckes said the pound also benefited from political upheaval in France that weakened the euro.
He added that if that risk disappeared, sterling could weaken “quite easily” from its current level of around 84 pence per euro to 86 pence.
