Market Analysis

Sterling has surged to its highest levels against the dollar in nearly two and a half years and is also performing strongly against the euro. However, analysts caution that this rise is driven by speculative interest rate bets, which could unravel quickly in markets still reeling from the turmoil experienced earlier in August.

Currently trading around $1.32, the British pound has exceeded most analysts' target prices for the year. This marks a remarkable recovery from its plunge to record lows near $1.03 following former UK Prime Minister Liz Truss's mini-Budget in September 2022.

The rally is largely attributed to expectations that the Bank of England (BoE) will maintain higher interest rates longer than the United States and the eurozone. However, this also makes sterling vulnerable to any shifts in monetary policy forecasts, according to currency traders and analysts.

"We're likely to see fluctuations in predicted easing paths over time, leading to increased volatility," said Nick Rees, a senior market analyst at Monex Europe. He added that sterling's current value reflects anticipated UK economic growth but overlooks the risk that the BoE could cut rates more quickly than markets currently expect.

Market predictions indicate that UK interest rates will remain higher than those in the U.S. a year from now. The BoE reduced rates by 25 basis points on August 1 to 5%, with money markets pricing in an additional 40 bps of cuts by year-end. Meanwhile, the European Central Bank is expected to reduce rates by 65 bps to 3% over the same period.

Carry Trade Concerns

Traders are cautious about sudden sell-offs in higher-interest-rate currencies, particularly after the recent collapse of an estimated $250 billion in carry trades, where speculators borrowed Japanese yen to invest in higher-yielding assets.

A significant unwind of yen-funded positions a few weeks ago caused substantial losses for higher-yielding currencies like Mexico's peso and South Africa's rand, raising concerns about sterling's popularity as a carry trade currency.

Several major investment banks are now recommending trades involving the use of the currently weak but unpredictable Swiss franc to fund purchases of sterling, according to their marketing materials.

"This is a high-risk trade that can generate small, steady profits but carries the risk of sudden, catastrophic losses," said Jonas Goltermann, head of FX markets at Capital Economics.

Debt-funded carry trades typically thrive in calm markets but can quickly encounter problems when volatility increases or interest rate expectations shift.

According to UBS's analysis of futures contracts, speculative traders using borrowed funds have dominated bets on sterling appreciating against the dollar for over a year, in a trade currently valued at $3.5 billion. Meanwhile, mainstream asset managers hold a $700 million net short position, indicating a negative long-term outlook on sterling.

Interest Rate Expectations

Sterling has gained nearly 3% against the euro year-to-date and is the top-performing major currency against the dollar, with a rise of 4%.

The pound's strength has been supported by hopes of increased political stability in Britain following the Labour Party's significant election win in July, as well as the economy's recovery from a shallow recession in 2023.

However, the new government's first Budget in October could present challenges, with potential spending cuts or tax increases aimed at managing Britain's high national debt, potentially hampering economic growth.

"All the positive news for the pound seems to be reflected in its price, while the negative news is largely ignored," said Goltermann.

Rob Wood, chief UK economist at Pantheon Macroeconomics, noted that if the BoE keeps rates high, it could suppress economic growth in the coming years, which might weigh on the pound.

Market Uncertainty

Shahab Jalinoos, Head of G10 FX Strategy at UBS, observed that foreign exchange markets remain uneasy following the early August yen shock, and tensions could escalate as the U.S. presidential election in November approaches.

Carry trades tend to perform well in stable markets, making sterling vulnerable to future volatility, Jalinoos said. "However, the current positioning is not so large as to prevent sterling from recovering once the dust settles."

Monex's Rees added that the pound's performance against the dollar might also be exaggerated due to thin summer trading conditions.

The Bank of International Settlements warned this week that while currency markets are relatively stable now, large positions accumulated during calm periods could unwind rapidly when volatility increases.

Kit Juckes, chief currency strategist at Societe Generale, noted that sterling has also benefited from political turmoil in France, which has weakened the euro. If this perceived risk diminishes, sterling could "easily" weaken to 86 pence per euro from its current level of around 84 pence, he said.

Paraphrasing text from "Reuters" all rights reserved by the original author.