LONDON Sterling is set to resume its fall against the dollar, options market prices indicate, with a possible change in the Bank of England's policy remit in this week's budget likely to hasten a drop to four-year lows.
Britain's pound is the worst performing major currency after the yen this year, coming under relentless selling pressure. It has lost 7 percent against the dollar and 5.5 percent versus the euro on risks of a triple-dip recession in Britain and prospects of further monetary easing.
Investor demand for options betting on the pound rising or falling against the dollar, as measured by the one-month risk reversals, shows the strongest preference for sterling weakness since last July.
"The risk reversals are pointing at more bearishness for sterling/dollar," said Olivier Korber, an options strategist at Societe Generale. "Lower growth forecasts would prompt the BoE to ease monetary policy."
Traders cite steady demand from hedge funds for options that would make money if sterling fell to $1.45 within three months. Most banks' have their year-end forecasts even lower.
True, sterling has picked up slightly since hitting a 33-month low of $1.4832 last week. Traders cite some demand for one-week options that bet the pound will rise to $1.53 from a few investors, from around $1.5120 on Tuesday.
But analysts say that with Britain struggling with near- zero growth and facing more spending cuts, any such gains would be fleeting and an opportunity to sell the pound.
Against this gloomy background, sterling is expected to lag currencies of countries whose economies are recovering, such as the United States.
Under pressure to kick-start the UK economy, speculation is swirling that Finance Minister George Osborne will announce with Wednesday's budget a review of the central bank's remit to give it more leeway on inflation targeting. That will allow the BoE more scope for further easing despite higher inflation.
"With the UK government set to announce a review, the risks are rising again that sterling depreciates further this year especially against the dollar," said Mansoor Mohiuddin, head of FX strategy at UBS. He has a year-end forecast for $1.41, a level last seen in March 2009 and not far from a $1.35 low struck during the global financial crisis.
Sterling's mini-recovery last week coincided with a rise in speculators' bets against the currency to their highest since late 2011. With such extreme positioning, some took profit, pushing sterling higher.
Expectations the U.S. Federal Reserve will stick with an ultra-loose monetary policy at a policy meeting this week this week that could pull the dollar lower have also helped sterling.
Finally, BoE Governor Mervyn King who had advocated a weaker pound to boost exports, did an about-face last week and said the currency's sharp drop had left it fairly valued.
A catalyst for further sterling gains could come from the minutes, due on Wednesday, of the BoE's latest policy meeting.
If fewer policymakers voted for more asset-buying easing measures, on concern that a weaker pound drives up inflation through more expensive imports, sterling could rise.
A rise to $1.53 would see those investors who bought options on it reaching that level make money.
"This demand is only from a handful of short-term investors. It does not signal a turnaround in sterling," said a chief options trader at a European bank in London. "The budget is unlikely to change the bias for more weakness."
Analysts said investors were more willing to express an unfavourable view about Britain by selling sterling against the dollar rather than the euro. Prospects of recession in the euro zone and concern about contagion from Cyprus would weigh on the single currency, they said.
While interest rate differentials between two-year German Bunds and UK government bonds, considered more sensitive to changes in monetary policy, have moved against the former since February, spreads between U.S. two-year bonds and their UK counterparts have widened to their highest since early November in favour of dollar assets.
"Fundamentally we see no reason to buy sterling," said Howard Jones, an advisor at money managers RMG Wealth Management and for whom the dollar is buy. "For medium-to-long-term investors, any rise in sterling to the mid-$1.50 is a sell."
On Monday, Morgan Stanley downgraded its sterling forecasts, warning about a potent mix of lower growth and higher inflation.
"Rising inflation expectations leave the UK with the most negative real yield in the G-10, undermining sterling. We have taken our forecast down to $1.43 for end-2013 and 1.41 for end-2014."
It earlier had a forecast of $1.60 and $1.45 respectively.
(Editing by Nigel Stephenson)