‘Better, but not good’: Investors cautious about sterling after rebound

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The pound is no longer in crisis, but traders are reluctant to position themselves for a prolonged rally as the Bank of England’s commitment to rapidly raising interest rates weakens in the face of a looming recession.

The pound’s recovery from its September plunge to an all-time low against the US dollar came to a halt last week. As doubts over the UK’s economic and political credibility that pushed the pound below $1.04 receded, investors took big bets against a currency crippled by a toxic mix of high inflation , a massive trade deficit and a bleak outlook for the UK economy. .

After climbing above $1.16 in late October, helped by new Prime Minister Rishi Sunak who ditched his predecessor Liz Truss’s tax cut and borrowing policies that sparked the September slump, the pound ended the week around $1.13. A decline this week, which eased on Friday when the dollar fell broadly against other currencies, came despite the BoE’s 0.75 percentage point hike, the largest in 30 years.

While Thursday’s sharp rate hike was widely anticipated, the BoE’s gloomy economic outlook has bolstered belief in currency markets that UK interest rates are likely to rise more slowly than those in the US or even the UK. eurozone. Investors typically pour money into markets that offer higher returns on fixed income assets.

“We had some sort of normality and the crisis premium was taken out of the pound by Sunak,” said Jane Foley, head of FX strategy at Rabobank. “But Thursday’s Bank of England meeting was a reminder that normalcy for the pound looks quite bleak.”

BoE Governor Andrew Bailey’s message that market expectations for further tightening are overblown contrasts with Federal Reserve Chairman Jay Powell, who said on Wednesday that investors were underestimating the peak in rates US interest rates after increasing borrowing costs by the same margin.

“We found out this week that not all 75 basis point hikes are equal,” said Kamakshya Trivedi, head of global currency strategy at Goldman Sachs. “The message from the Fed was much more hawkish. US economic resilience is going to become increasingly apparent compared to places like the UK where tightening is likely to be more gradual and reluctant.

Following the recent change of government in the UK, “the outlook for the pound is better, but not good,” added Trivedi.

The pound’s recent weakness isn’t just against a creeping dollar. On Friday, the pound hit a low of £0.878 against the euro which, excluding the volatile period during Truss’s premiership, has not fallen since February last year.

In a note released ahead of the BoE meeting, Deutsche Bank FX strategist Shreyas Gopal said the pound’s “crisis chapter” was over, but the UK’s current account deficit – which widened to a record 7.2% of GDP in the first quarter before declining to 5.5% in the following three months — remained a significant headwind for the currency. The current account deficit, which includes the UK’s trade balance as well as net foreign investment and transfer income, provides insight into the economy‘s dependence on foreign capital inflows.

Gopal, who expects the pound to fall back to $1.08 by the end of the year, said: “The UK’s external funding needs remain significant and, at current market prices , real yields are still too low relative to other major currencies, which are all otherwise equal, leaving the pound’s likely downtrend.

Many investors seem to agree. Bearish bets on the value of the pound are roughly on par with those seen before and after Truss’ ill-fated ‘mini’ budget, according to data from the U.S. Commodity Futures Trading Commission which provides insight into the how currency speculators, such as hedge funds, position themselves.

During the crisis following Truss’ tax package of unfunded tax cuts, soaring UK bond yields did little to support the pound’s fall.

The synchronized sale of bonds and sterling was reminiscent of an emerging market crisis, where investors lose confidence in a country and sell off assets of all kinds. Sunak’s fiscal policy reversals stabilized the gilt market, but also saw the return of a more typical correlation, where lower bond yields relative to those in other economies tend to weaken the currency.

The UK 10-year yield rose 0.5 percentage points above its US equivalent in early October. It has since fallen back to 0.6 percentage points below the 10-year Treasury yield, the biggest gap since August. The extra yield offered by gilts over German debt has also narrowed to levels last seen before Truss’ fiscal plans, as has the spread of so-called real yields which are adjusted for interest rates. expected inflation.

Line graph of the difference in 10-year government bond yields (percentage points) showing that the UK's yield advantage over the US disappears

“When you have such a large current account deficit, you need either higher interest rates or a weaker currency to attract the inflows needed for financing,” said Ugo Lancioni, head of currency management at US asset manager Neuberger Berman, which is positioned for more sterling. short-term weakness. “It seems the preference is for a weaker pound.”

Looking further ahead, the scale of the dollar’s rise against a swathe of currencies, including the pound sterling – which is down around 17% so far this year – raises hopes for a recovery in the pound, the less against the US currency, according to Lancioni.

As U.S. inflation and interest rates peak, some of the dollar’s “excessive strength” is likely to recede, he said, although the timing is hard to pinpoint.

“A year from now, I would expect the pound to be higher against the dollar,” Lancioni said. “But that’s a low-confidence forecast.”

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