HomeBlogFinance‘Better, but not good’: investors cautious on sterling after rebound

‘Better, but not good’: investors cautious on sterling after rebound

Sterling is no longer in crisis, but currency traders are reluctant to position for a prolonged rebound as the Bank of England’s commitment to rapid interest rate rises wanes in the face of a looming recession.

The pound’s recovery from its September plunge to an all-time low against the US dollar has stalled in the past week. While the doubts about the UK’s economic and political credibility that drove the pound below $1.04 have receded, investors have stuck with sizeable bets against a currency hamstrung by a toxic mix of high inflation, a massive trade deficit, and a bleak outlook for the UK economy.

Having climbed above $1.16 in late October, helped by new prime minister Rishi Sunak ditching the tax-cutting and borrowing policies of predecessor Liz Truss that sparked September’s meltdown, sterling finished the week around $1.13. A slide this week, which was dulled on Friday when the dollar fell broadly against other currencies, came despite the BoE’s 0.75 percentage point rate increase, the biggest in 30 years.

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

“We’ve had some kind of normality come back and the crisis premium removed from sterling by Sunak,” said Jane Foley, head of FX strategy at Rabobank. “But Thursday’s Bank of England meeting was a reminder that normality for the pound looks pretty grim.”

BoE governor Andrew Bailey’s message that market expectations for further tightening are overdone stood in contrast to Federal Reserve chair Jay Powell, who said on Wednesday that investors were underestimating the peak in US interest rates after lifting borrowing costs by the same margin.

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

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

The pound’s recent weakness is not solely against a rampant dollar. On Friday, sterling touched a low of £0.878 to the euro which — excluding the volatile period during Truss’s premiership — it has not plumbed since February last year.

In a note published ahead of the BoE meeting, Deutsche Bank FX strategist Shreyas Gopal said the “crisis chapter” for sterling was over but that the UK’s current account deficit — which widened to a record 7.2 per cent of GDP in the first quarter before receding to 5.5 per cent in the following three-month period — remained a significant headwind for the currency. The current account deficit, which includes the UK’s trade balance as well as net income from foreign investment and transfers, provides a snapshot of the economy’s reliance on foreign inflows of money.

Gopal, who expects sterling to fall back to $1.08 by the end of the year, said: “The UK’s external financing needs remain large and, on current market pricing, real yields are still too low compared to other major currencies, which all else equal leaves the likely trend in the pound lower.” 

Many investors appear to agree. Bearish wagers on the value of the pound are roughly at the same level seen in the run-up to and aftermath of Truss’s ill-fated “mini” Budget, according to data from the US Commodity Futures Trading Commission that provide a snapshot of how currency speculators, such as hedge funds, are positioned.

During the crisis which followed Truss’s fiscal package of unfunded tax cuts, soaring UK bond yields did little to prop up the plunging pound.

The synchronised sell-off in bonds and sterling was reminiscent of an emerging markets crisis, where investors lose confidence in a country and sell assets of all stripes. Sunak’s fiscal policy U-turns have stabilised the gilt market, but also seen the return of a more typical correlation, where lower bond yields relative to those in other economies tends to weaken the currency.

The UK’s 10-year yield rose as much as 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 relative to German debt has also narrowed to levels last seen before Truss’s fiscal plans as has the gap in so-called real yields which are adjusted for expected rates of inflation.

“When you have such a large current account deficit you either need higher interest rates or a lower currency to attract the inflows to fund it,” said Ugo Lancioni, head of currency management at US asset manager Neuberger Berman, who is positioned for further sterling weakness in the short term. “It looks like the preference is for a weaker pound.”

Longer term, the sheer scale of the dollar’s rise against a swath of currencies including sterling — which is down around 17 per cent so far this year — provides some hope of a recovery for the pound, at least against the US currency, according to Lancioni.

As US inflation and interest rates peak, some of the dollar’s “excessive strength” should recede, he said, although the timing is tough to call.

“In one year I would expect the pound to be higher against the dollar,” Lancioni said. “But it’s a low confidence forecast.”

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