By Naomi Rovnick
LONDON (Reuters) – Sterling hit a near 2-1/2-year high against the dollar and soared against the euro in moves analysts warned were fuelled by speculative interest rate bets that could quickly unravel in markets still shaken by the country’s turmoil in early August.
Sterling has risen above most analysts’ target for the year at around $1.32, a stunning recovery from a drop to record lows near $1.03 after former British Prime Minister Liz Truss’ mini-budget in September 2022.
Currency traders and analysts said expectations that the Bank of England will keep interest rates higher for longer than the United States and the euro zone explain the rise but also make sterling vulnerable if monetary policy expectations change.
“We will see deviations in the easing paths being priced in over time, and that should lead to increased volatility,” said Nick Rees, chief market analyst at Monex Europe.
He added that the current value of the pound reflects expected economic growth in the United Kingdom but ignores the risk of the Bank of England cutting interest rates faster than markets currently expect.
Traders expect UK interest rates to be higher than those in the US within a year. The Bank of England cut rates by 25 basis points on August 1 to 5%, and financial markets are pricing in a further 40 basis point cut 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.
Do you keep buying?
Traders are worried about a sudden sell-off in high-interest-rate currencies after an estimated $250 billion in so-called carry trades collapsed this month, where speculators borrowed Japanese yen to buy higher-yielding assets.
Massive liquidations of yen-funded positions a few weeks ago have hurt higher-yielding currencies, from the Mexican peso to the US dollar, highlighting the popularity of sterling as a carry trade buy.
Marketing materials from at least three major investment banks have shown them recommending trades that involve using the currently weak but often unpredictable Swiss franc as a financing vehicle to buy sterling.
“These are pennies on the head of a bull market,” said Jonas Goltermann, head of foreign exchange markets at Capital Economics, referring to investments that can generate small steady profits but come with the risk of catastrophic sudden losses.
Debt-financed trading generally thrives 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 on the pound rising against the dollar for more than a year, with trades now worth $3.5 billion, according to an analysis of futures contracts by UBS.
The same data showed that major asset managers hold net short positions worth $700 million, suggesting that these longer-term investors have a negative view of sterling in general.
Betting Evaluation
The pound has risen about 3% against the euro since the start of the year, and was the best performing major currency against the dollar, up 4%.
This optimism has been boosted by hopes of improved political stability in Britain after the Labour Party’s landslide election victory last July, as well as an economic recovery from a shallow recession in 2023.
However, the new government’s first budget in October risks spending cuts or tax increases, which could keep Britain’s high national debt in check but could hurt growth.
“All the good news for sterling now lies in the price, and there doesn’t seem to be any bad news,” Goltermann said.
Rob Wood, chief UK economist at Pantheon Macroeconomics, said that keeping interest rates high by the Bank of England could lead to a suppression of the economy in the coming years, which could weigh on the pound.
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UBS’s head of G10 FX strategy, Shehab Galinos, said FX markets remained tense after the yen shock in early August and tensions could rise as the US presidential election approaches in November.
He added that trading tends to flourish when markets are quiet, making sterling vulnerable to future bouts of volatility.
“But the situation is not so dire that sterling could recover once things settle down again.”
Monex’s Rees said the pound’s performance against the dollar may also have been overstated due to poor trading conditions in the summer.
The Bank for International Settlements warned this week that while currency markets are not currently volatile, large positions built up during calm periods could quickly be wiped out when volatility rises.
The pound also benefited from political unrest in France that undermined the euro, said Kit Juckes, chief currency strategist at Societe Generale.
If that perceived risk were to fade, he said, sterling could “fairly easily” weaken to 86 pence against the euro from around 84 pence currently.