Sterling bulls face reckoning after currency’s best week this year

LONDON – Traders who drove the pound to its best week of the year have a lot riding on the next inflation report, where even a faster-than-expected rate could work against them.

Pricing in the options market suggests investors are already revving up to sell, concerned that something in the economy will eventually break under the weight of ever-higher rates. Positioning is also looking stretched as traders trim the most-bullish wagers in half a decade.

For months, investors have been piling in to lock in juicier returns as accelerating inflation forced the Bank of England (BOE) to push ahead with

its most aggressive tightening drive in a generation.

The British currency rose from a record low in September to end the week near US$1.30.

But the worry is that the pound will suffer regardless of how lofty the rate is, and the numbers this Wednesday may mark the point where sterling bulls capitulate.

“Elevated levels of inflation, coupled with weaker growth, are not necessarily a positive for the currency even if interest rates are going up,” said foreign exchange strategist David Adams at Morgan Stanley in London.

British inflation came in stronger than expected

in each of the past four months, fuelling wagers that the BOE would have to keep raising rates faster than its developed nation peers.

Since then,

inflation in the United States had come in below forecasts,

bolstering the case for an even slower pace of increases. Yet currency strategists and market positioning show pressure building for the pound to go into retreat regardless.

Nomura Holdings sees the euro climbing almost 3 per cent against the pound to 0.88 by the end of September, while Morgan Stanley envisages a 6 per cent gain for the common currency by mid-2024.

Monex USA, the most accurate predictor of the pound’s moves against the greenback in Bloomberg’s second-quarter poll, sees the pound slipping back to US$1.29 by the end of 2023. JP Morgan says it will be around 9 per cent weaker at US$1.19 by year end.

While the recent slowdown in US inflation boosted appetite for options to sell the US dollar against most currencies, many traders avoided dumping it for the pound, according to trading solutions provider DTCC. What is more, speculative traders have begun to trim bullish wagers on sterling after extending them to the strongest in more than five years in the run-up to the last BOE meeting in June, data shows.

Still, even if the Wednesday numbers show inflation that is starting to come off, it remains at levels last seen in the 1980s, which will require the BOE to keep hiking, according to Mr Michael Cahill, foreign exchange strategist at Goldman Sachs, who sees the pound up about 1.4 per cent at US$1.33 in 12 months’ time.

“The UK has the highest nominal rates in the G-10 (Group of 10 economies), but also the lowest real rates in the G-10,” he said. “We’ve got still very strong inflation and wages. It calls pretty clearly for tight policy and that should benefit the currency.” BLOOMBERG