By Naomi Rovnick
LONDON (Reuters) – Sterling has hit about a 2-1/2 year high against the dollar and is flying high against the euro. Analysts warn the moves are underpinned by speculative interest rate risks that could quickly unravel in markets still reeling from early August’s turmoil.
At around $1.32, the British pound has risen above most analysts’ target prices this year. It’s a stunning recovery from the slump to a record low of almost $1.03 following former British Prime Minister Liz Truss’ mini-budget for September 2022.
Predictions that the Bank of England will keep interest rates high for longer than in the United States and the euro zone explain the rally, but also leave the British pound vulnerable if monetary policy forecasts change, currency traders and analysts said.
“We will see deviations in (predictions of) easing paths over time and that should lead to greater volatility,” said Nick Rees, senior market analyst at Monex Europe.
The current value of the pound, he added, reflected expected economic growth in the UK, but had ignored the risk that the BoE would cut interest rates faster than markets now forecast.
Traders predict that in a year’s time, UK interest rates will be higher than those in the US. The BoE cut rates by 25 basis points on August 1 to 5% and money markets are pricing in another 40 basis points of rate cuts by the end of the year. The European Central Bank is expected to ease by 65 basis points to 3% over the same period.
CONTINUE BUYING?
Traders are wary of sudden selloffs in higher-yield currencies after this month’s implosion of an estimated $250 billion in so-called carry trades, in which speculators borrowed the Japanese yen to buy higher-yielding assets.
A massive pullback in yen-funded positions just weeks ago wreaked havoc on higher-yielding currencies from the Mexican peso to , putting the spotlight on the British pound’s popularity as a carry trade purchase.
At least three major investment banks are recommending deals that use the currently weak but often unpredictable Swiss franc as a financing vehicle to buy British pounds, their marketing materials showed.
“This is a penny before a steamroller trade,” said Jonas Goltermann, head of FX markets at Capital Economics, referring to investments that can generate small steady profits but carry the risk of sudden, catastrophic losses.
Debt-financed carry trades generally thrive when markets are calm and can quickly run into trouble when markets become volatile or interest rate expectations change.
Speculative traders using borrowed money have dominated bets that the British pound will rise against the dollar for more than a year in a trade currently worth $3.5 billion, according to a UBS analysis of futures contracts.
Mainstream asset managers have a net short position of $700 million, the same data showed, suggesting that these longer-term investors have a negative view of the pound overall.
RATE BETTINGS
Pound sterling is up almost 3% against the euro this year and is the best performing major currency against the dollar, up 4%.
It is boosted by hopes for improved political stability in Britain after the Labor Party’s major election victory in July, and by the economy’s recovery from a shallow recession in 2023.
Still, the new government’s first budget in October carries the risk of spending cuts or tax increases that could keep Britain’s high public debt in check but could hurt growth.
“All the good news for the pound is now in the price, and apparently none of the bad news,” Goltermann said.
Rob Wood, chief Britain economist at Pantheon Macroeconomics, said the BoE keeping interest rates high could depress the economy in coming years, potentially pushing the pound down.
BOLD
UBS’s head of G10 FX Strategy, Shahab Jalinoos, said currency markets remained tense after the yen shock in early August and could become even more tense as the US presidential election approaches in November.
Carry trades tend to flourish when markets are calm, leaving the pound vulnerable to future bouts of volatility, he said.
“But the positioning is not so strong as to rule out the possibility of sterling’s recovery once the dust settles.”
The pound’s performance against the dollar was also likely exaggerated by poor trading conditions over the summer, Monex’s Rees said.
The Bank of International Settlements warned this week that while currency markets were not currently turbulent, large positions built up during periods of calm could unwind quickly as volatility increases.
Societe Generale (OTC) chief currency strategist Kit Juckes said the pound had also benefited from political unrest in France that was undermining the euro.
If this perceived risk disappears, sterling could weaken “quite easily” from around 84 pence currently to 86 pence per euro, he said.
