Investors bet against pound over ‘dire’ threat of stagflation

Investors are lining up bets that the pound will fall further after a tough start to 2022 as a “dire” mix of towering inflation and slowing growth darkens the UK’s economic outlook.

Wagers that sterling will fall are near their highest level in almost three years, according to Commodity Futures Trading Commission data, which track how speculative investors are positioned in futures contracts, a proxy for sentiment in the $6.6tn-a-day foreign currency market.

Even as Boris Johnson survived a parliamentary confidence vote this week — potentially averting a period of political turmoil — markets are focused on the gloomy economic backdrop, say analysts, meaning the UK prime minister’s victory is unlikely to prompt a change in course for the currency.

Sterling whipped back and forth around Monday’s vote, but on Thursday traded close to where it was against the US dollar a week ago at $1.254. It has shed 7 per cent this year against the dollar.

Currency traders say the implications of Johnson’s win were muddied by uncertainty over who might have replaced him. At the same time, the political twists and turns largely remain a sideshow for a foreign exchange market focused on the potential for a UK recession later this year, which could halt the Bank of England’s efforts to tame inflation by raising interest rates.

“The market is very bearish on sterling,” said Sam Lynton-Brown, head of developed markets strategy at BNP Paribas. “Domestic political uncertainty hasn’t been a big driver of the currency. So even if it alleviates, you shouldn’t expect the pound to recover. We still think it can weaken further.”

The BoE has lifted interest rates four times since it began to tighten monetary policy in December — well ahead of counterparts such as the US Federal Reserve and the European Central Bank. Even so, the pound has lost ground against the euro and the dollar this year as investors begin to wonder how long borrowing costs can continue to rise with consumers facing an acute cost of living crisis.

“By the time we get into the autumn in the UK, the impact on household incomes of inflation but also of higher rates will be so marked that the window of opportunity for the BoE to raise rates will be closing,” said Jane Foley, head of currency strategy at Rabobank.

The problem of how to rein in inflation without choking off growth is not unique to the BoE. But some investors worry the UK’s dilemma is more acute than that faced by other big developed economies. The OECD on Wednesday forecast that the UK economy will grind to a halt next year, with only sanctions-hit Russia faring worse among G20 nations.

Chart showing the fall in sterling

“Even as inflation comes back down in other major economies, we are likely to have a more persistent problem in the UK,” said Mark Dowding, chief investment officer of BlueBay Asset Management. “A stagflationary environment will be pretty dire for all UK assets and for the pound,” he said, describing the blend of surging prices and slowing growth. “We could end up with a scenario where the pound is on its way to parity with both the euro and the dollar.”

Recent comments from governor Andrew Bailey that the BoE is “helpless” to fight inflation have not helped, according to Dowding.

“Even if they think that — they shouldn’t be telling everyone. It’s only going to push up inflation expectations even further,” he said.

Lynton-Brown said stubbornly high inflation would hit foreign demand for UK government debt, which trades at some of the lowest inflation-adjusted yields in the world. Without persistent inflows into gilts to fund the UK’s current account deficit, the exchange rate would have to adjust lower, he said.

For some analysts, the gloom surrounding sterling could actually be a source of resilience in the short term.

A global rebound in stock markets would likely boost the pound, which tends to move in tandem with riskier assets, as bearish investors exit their short positions, according to Nomura strategist Jordan Rochester.

Investors might also embrace a renewed threat to Johnson’s position, betting that his successor would be less likely to inflame trade tensions with the EU by ditching the post-Brexit trade deal for Northern Ireland, he said.

“The market has become so negative on politics in the UK that it tends to lean towards the positive if there’s any promise of change,” said Rochester. “But you have to be careful because we don’t know what a change of leadership means for policy, for spending, or for reform, because we don’t know who comes next.”

“The next Tory leader might not be racing to tear up the Northern Ireland protocol, but you could also get an even harder Brexiter,” he added.