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Foreign Exchange

Prepare for end of sterling bull trend

An intensification of the eurozone risks, highlighted by the Bank of England (BoE) in its quarterly Inflation Report, could be the catalyst for sterling’s retracement of its recent gains.

Analysts say a correction in GBPUSD looks likely, though the steady grind lower in EURGBP might have further to run. GBP has been among the best-performing G10 currencies against the dollar this quarter, as the market revised down expectations of further quantitative easing (QE) and instead began to price in an apparently more hawkish stance from the BoE.

While many have attributed sterling’s rise to safe-haven flows as having resulted from increased risk aversion, Barclays’ model of short-term drivers suggests moves in relative interest rates were more important drivers rather than proxies for risk sentiment – captured by moves in equity markets.

 

Source: IFR However, the financial and economic risk posed to the UK from the intensification of the eurozone crisis – an issue the BoE emphasized in its latest Inflation report – might see the pound catch up with some of its peers and weaken against the dollar.

To the extent that sterling traders believe the Bank’s gloomy outlook for the UK economy might affect future policy, they might reconsider their revised-down probabilities for further QE, which helped fuel the sterling bull run.

“The Bank of England’s inflation projections were below expectations and the inflation report could be a signalling tool from the Bank to prepare the market for further easing and a longer period of low rates than they may have previously been expecting,” says Ankita Dudani, FX strategist at the Royal Bank of Scotland.

While GBPUSD is now nearly three big figures below last month’s highs around $1.62, the unwinding of the overcrowded sterling long position might have further to go, says Dudani, targeting $1.57 by June.

Against the euro, the pound is still close to multi-year highs, with EURGBP moving under £0.80 for the first time since autumn 2008. This is a level that might mark the end of the pound’s steady appreciation against the beleaguered single currency.

Positioning has become overcrowded and short EURGBP below £0.80 does not offer the good value we saw between £0.82-83, says Dudani.

CFTC positioning data could indicate potential for a short squeeze
Source: Barclays

Valentin Marinov, FX strategist at Citi who previously described EURGBP as the short-EUR proxy of choice, says a move below the £0.78 mark – the low in the autumn 2008 – seems unlikely, taking into account the UK’s weak fundamentals and the tail-risks posed by a eurozone catastrophe. However, if it is relative interest-rate expectations that have been behind the pound’s rise against the euro, then EURGBP’s downward trend might well continue.

“What we’ve seen so far is the MPC is willing to look through weak data in response to sticky inflation and with this in mind the Bank of England is likely to have a less accommodative policy than the ECB,” says Sara Yates, FX strategists and sterling expert at Barclays Capital.

While QE in isolation is a sterling negative, the Bank is only likely to re-engage this policy if eurozone risks were to escalate significantly, says Yates.

In that environment, the euro would be at the epicentre of the crisis, and would weaken more heavily than the pound, particularly as the response from the ECB would very likely be that of further loosening.

“That, coupled with an additional risk premium on the euro, should see EURGBP grind lower, with 0.76 the target by year end,” says Yates.

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