Buy Sterling on a ‘Brexit Breakthrough’? Not Yet, Say Investors
LONDON—Sterling investors remain hesitant about chasing the rallying pound higher, even as the British government says it is close to an agreement with the European Union on how to move Brexit talks on to trade next year.
British hopes of securing a deal with the European Union were dashed on Dec. 4 by Prime Minister Theresa May’s kingmakers in Belfast. The government is holding fresh talks and said on Dec. 5 it remained confident it will reach an agreement.
After spending most of 2017 on the back foot against a broadly weak dollar, market expectations on sterling have shifted considerably in recent weeks toward betting on a breakthrough in Brexit negotiations, with the British currency rising to a two-month high on Dec. 1.
High-frequency indicators of market positioning and options market hedging have also shifted markedly to show green shoots of optimism emerging.
Speculative bets on sterling, shown in data compiled by the U.S. Commodity Futures Trading Commission (CFTC) and often seen as a proxy for hedge fund positioning, outweighed those betting on a fall in sterling for the first time since the Bank of England raised interest rates in early November.
Prior to that brief flurry before the rate rise, there had not been a net long position in sterling since October 2015.
What’s more, the costs of one-month options to buy sterling in the derivatives market exceed that of options to sell it for the first time since October this year.
But despite sterling’s bounce in recent days, investors remain wary about the currency’s outlook, pointing to the underlying weakness of the British economy, and the long, complicated negotiations to come before Brexit becomes a reality in 2019.
“There is still a lot of work to be done before we get any clarity, and to take big positions in this headline-driven market is fraught with dangers,” said James Binny, head of currencies at U.S. financial group State Street Global Advisors in London.
So despite a cautious return in long sterling bets in the currency markets, the duration of those positions has become shorter, indicating how nervous the markets are.
So far, these net sterling long bets are only a week old, compared to those in October, which remained for a month. The longest duration of long sterling bets was a year, between September 2013 and late 2014, according to CFTC data.
At the heart of this nervousness is a view that any Brexit outcome, whether “soft” or “hard,” will weigh on the economy at a time when other major world economies, such as Europe and the United States, are firing on all cylinders.
“The key issue for sterling is that, from an economic standpoint, it looks tough, and any bounce after a Brexit talks breakthrough will be a ‘buy the rumor and sell the fact’ trade,” said Richard Benson, co-head of portfolio investments at Millennium Global Investments Ltd. in London.
To be sure, a breakthrough in the talks would lift the fog of uncertainty hanging over British companies, encouraging them to invest more and ultimately lift economic activity.
Despite the breakdown in talks on the Ireland border issue at the last minute on Dec. 4, foreign exchange derivative markets are betting on a breakthrough.
Kallum Pickering, senior UK economist at Berenberg in London, expects a transition deal to materialize by late 2018, an outcome that would boost economic growth to 1.8 percent.
It would also lead to a significant revaluation of sterling, which, according to SSGA’s Binny, is trading at about 15 percent cheaper against the dollar on a valuation basis.
Walking a Fine Line
But even assuming a successful negotiation of the complex series of Brexit talks, sterling still has considerable headwinds against its two major rivals, namely the dollar and the euro.
Some market participants expect the United States to raise interest rates by as much as four times over the next 12 months, after a landmark tax code overhaul on Dec. 2.
John Taylor, senior fixed income portfolio manager at Alliance Bernstein in London, said the UK will have to raise rates by two times “to hang on to the coat tails of the Fed.”
“The Bank of England can’t afford to not tighten at all, as that would weaken the currency a lot, and if they hike more, they may end up tipping the economy into recession well before Brexit kicks in,” said Taylor.
“Sterling movements have become knee-jerk and pavlovian depending on the headline of the day, and institutional investors are now focusing on the economic data,” said Marc Ostwald, a market strategist at ADM Investor Services.