Analysis – Pound’s stunning rise keeps currency markets jittery on edge By Reuters

By Naomi Rovnick

LONDON (Reuters) – Sterling has hit around 2½-year highs against the dollar and is soaring against the euro, in moves analysts warn are underpinned by speculative bets on interest rates that could unravel quickly in still-shaky markets by the turbulence of early August. .

At around $1.32, the British pound has risen above most analysts’ price targets for this year. It’s a stunning recovery from its plunge to record lows of nearly $1.03 following former British Prime Minister Liz Truss’ September 2022 mini-budget.

Forecasts by the Bank of England to keep interest rates high for longer than in the United States and the euro zone explain the rise, but also make sterling vulnerable if monetary policy forecasts change, currency dealers and analysts said.

“We will see deviations from (predictions of) price relaxation paths over time and that should lead to increased volatility,” said Nick Rees, senior market analyst at Monex Europe.

The current value of sterling, he added, reflects expected economic growth in the UK, but ignored the risk that the BoE could cut rates faster than markets are currently predicting.

Traders predict UK rates will be higher than US rates a year from now. The BoE cut rates by 25 basis points on August 1 to 5%, and money markets are pricing in another 40 basis points of cuts by the end of the year. The European Central Bank is expected to drop 65bp to 3% over the same period.

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Traders are wary of a sudden selloff in higher-yielding currencies after the implosion this month of about $250 billion in so-called carry deals, in which speculators borrowed Japanese yen to buy higher-yielding assets.

A massive relaunch of yen-backed positions just a few weeks ago wreaked havoc on higher-yielding currencies from the Mexican peso to , putting the pound’s popularity as a carry buy into the spotlight.

At least three major investment banks are recommending deals involving the use of the weak but often unpredictable Swiss franc as a means of financing to buy pounds, their marketing materials showed.

“This is a penny in the face of a steamroller transaction,” said Capital Economics head of currency markets Jonas Goltermann, referring to investments that can generate small, steady returns but carry the risk of sudden, catastrophic losses.

Debt-financed transportation operations 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 funds have dominated bets that the pound will appreciate against the dollar for more than a year, in a trade currently worth $3.5 billion, according to a UBS analysis of futures contracts.

The main asset managers have a net short position of $700 million, the same data showed, suggesting that these long-term investors have a negative view of the pound as a whole.

BETTING RATE

Sterling is almost 3% higher against the euro year to date and the best performing major against the dollar, up 4%.

It was supported by hopes of improved political stability in Britain after July’s big election victory for the Labor Party, as well as the economy rebounding from a shallow recession in 2023.

However, the new government’s first budget in October carries risks of spending cuts or tax increases that could keep Britain’s high national debt under control but could hurt growth.

“All the good news for sterling is now priced in and apparently none of the bad news,” Goltermann said.

Rob Wood, chief UK economist at Pantheon Macroeconomics, said keeping rates high by the BoE could suppress the economy for years to come, potentially depressing sterling.

EDGY

UBS Head of G10 Currency Strategy Shahab Jalinoos said currency markets remained tight after the yen’s shock in early August and could become more so as the US presidential election approaches in November.

Shipping operations tend to thrive when markets are calm, making the pound vulnerable to future bouts of volatility, he said.

“But the positioning is not so enormous that it precludes the possibility of sterling recovering once the dust settles again.”

The pound’s performance against the dollar was also likely exaggerated by weak trading conditions over the summer, Monex’s Rees said.

The Bank for International Settlements warned this week that while currency markets were not turbulent at the moment, large positions built up during calm periods could unwind quickly when volatility rises.

Kit Juckes, chief currency strategist at Societe Generale ( OTC: ), said the pound also benefited from political upheaval in France, undermining the euro.

If that perceived risk disappears, sterling could weaken “quite easily” to 86 pence to the euro, from around 84 pence currently, he said.