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Foreign Exchange

Sterling bears cling on as pound hits three-month high

Sterling continues to defy bearish expectations, powering to a three-month high against the dollar after UK manufacturing data beat expectations.

The news, which came before the Bank of England (BoE) – as expected – left UK interest rates unchanged at 0.5% and held its asset purchase plan at £375 billion, helped subdue expectations of further quantitative easing (QE) from the central bank.

The data added to a run of improved economic data, which began last month as figures showed that the UK economy avoided a triple-dip recession in the first quarter. Since then, GBPUSD has rallied nearly four big figures and stands just shy of $1.56, its strongest level since February.

Still, as the chart below shows, while speculators have trimmed their short positions in the pound during the past month, there remain substantial bets in the market hoping for a weaker pound.  

 Short sterling positions on CME pared back but still elevated

Sterling bears have, in other words, had a painful ride. For some, however, the rise in sterling witnessed during the past month represents a selling opportunity.

Deutsche Bank, for example, believes the squeeze higher in the pound during the past few weeks is a chance to add to short positions.

George Saravelos, strategist at Deutsche, thinks, perhaps counter-intuitively, that the recent run of positive UK data surprises is bearish, not bullish, for sterling.

He believes that, unlike the Federal Reserve, the BoE is unlikely to shift towards less monetary easing anytime this year, therefore the market cannot price in much in terms of relative monetary policy tightening in the UK.

“In contrast, sterling correlations with risk appetite – for example the FTSE – have shifted to negative over last two years,” says Saravelos.

“Improved risk appetite is associated with higher portfolio outflows from the UK given the extremely low level of real yields – the lowest in the world.”  

 Negative yields encourage outflows even if UK data better

The dynamics of the UK balance of payments is also a concern, according to Saravelos, with portfolio inflows remaining exceptionally weak due to negative real yields.

The trade balance is stuck in deficit due to the high share of the services sector in the UK economy and rising unit labour costs, but potentially more damaging is a rapidly deteriorating investment income balance.

“For any emerging market country, this deterioration would flash warning lights on the sustainability of the external position,” says Saravelos.

“This is very negative in the UK and growing.”

Furthermore, the situation in the UK stands in stark contrast to the US. Even though both countries have current account deficits, the UK appears to be suffering from a more structural decline in the relative profitability of its foreign investments.

This, says Saravelos – who believes sterling will decline between 5% and 10% on a trade-weighted basis from current levels – points to a structural decline in the UK financial system’s capacity to transform foreign safe-haven inflows into higher-yielding foreign assets.  

 UK investment income balance flashing red

Of course, the drying up of those safe-haven flows as eurozone government debt yield spreads tighten and worries over the break-up of the currency bloc ease is another reason to look for weakness in the pound. The UK was, after all, the main beneficiary of funds that left the eurozone in search of safety as the region’s debt crisis escalated.

In the longer-term, intensifying domestic debate over the UK’s membership of the European Union is unlikely to instil confidence in the country’s growth prospects or boost demand for sterling.

Still, with little near-term impetus for the BoE to engage in further QE, sterling bears might continue to be frustrated for the time being.

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