Pound weakness threatens markets

Asharp slump in the pound is imperiling more than $5.5 billion (R105 billion) of bets on further strength. The currency is on track for its biggest weekly drop of the year after the Bank of England laid the groundwork for a shift to interest-rate cuts, torpedoing a view among traders that the UK central bank would take longer than its peers in Europe and the US to act.

It’s a rapid about-face for markets. With the pound outperforming more than 90% of global currencies just two weeks ago, speculative investors — a category that includes hedge funds and asset managers — boosted bets in favor of sterling to the highest since July 2007.

But those $5.5 billion wagers now look overdone, and market participants warn a rapid unwind could prompt a deeper selloff in the pound.

“The risks of a prolongation of the short squeeze look high,” said Roberto Cobo Garcia, head of G-10 FX strategy at Banco Bilbao Vizcaya Argentaria SA in Madrid. “With the BOE poised to cut sooner than expected, and with stretched positioning and valuations, the trend may have started to revert.”

The pound’s drop also boosted demand for options that payout if the currency falls. So-called risk reversals — a barometer of market positioning that compares the demand to buy a currency versus the appetite to sell — now show the most bearish sentiment for sterling since November.

It all comes as traders increased bets the BOE will deliver its first quarter-point cut in June, as two of the most hawkish members dropped their calls for hikes on Thursday’s decision that left rates steady at 5.25%. That means the UK would move in lockstep with the Federal Reserve and the European Central Bank, which are also seen cutting for the first time on that month.

Earlier this year, expectations were euroarea and US policymakers would act sooner and deliver more cuts. Now, the amount of easing priced in for the BOE — about 80 basis points — is widely in line with what’s seen coming from the Fed. Bets are slightly more aggressive for the ECB, at around 90 basis points.

“This is a clear shift in tone, and it will make people more cautious about the UK rate outlook being that different than other central banks,” said Dominic Bunning, head of European FX research at HSBC Bank Plc. “It takes juice out of the pound.”

Bunning expects the pound to fall to $1.20 in the second half of the year, when the BOE starts to cut rates. On Friday, it traded at $1.26, down 1.2% this week.

Neil Mehta, a portfolio manager at RBC Bluebay Asset Management, lists other risks to the pound this year, including the prospect of a change in the UK government following a vote expected later in the year. — Bloomberg