RPT-Buoyant sterling seen drifting after dash to price in rate hikes

Fri Oct 25, 2013 2:54am EDT

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By Anirban Nag

LONDON, Oct 24 (Reuters) - Sterling's rally in the past three months on surprisingly strong economic data is losing momentum with investors wondering if they have been too aggressive in anticipating rate rises from the Bank of England.

Speculators including hedge funds, who have driven the pound nearly 10 percent higher against the dollar since July, have bought the currency in recent days on expectations of robust third-quarter growth data, due out on Friday.

The British economy is forecast to have grown 0.8 percent, faster than in the previous three months, and 1.5 percent year-on-year. By contrast, recovery in the United States seems to be faltering and the euro zone is just emerging from recession.

More forecast-beating numbers should underpin expectations the British central bank will tighten policy much sooner than it flagged in its controversial "forward guidance" in August.

Yet some analysts say investors have jumped so far ahead of themselves in pricing in earlier-than-expected rate hikes that the impact of forecast-beating data may diminish.

"Given how bullish investors have been in the run-up to the GDP data, which is expected to be good, there is a chance that if it disappoints, you could see a correction in sterling/dollar," said Sebastien Galy, currency strategist at Societe Generale in New York.

"We expect some consolidation before it can move higher."

Losses, though, may be seen as a buying opportunity by investors such as reserve managers, given expectations the British economy is firmly on the path of recovery.

Sterling gained 6 percent in August and September, soaring to $1.6260 on Oct. 1, its highest since early January. It is up nearly 10 percent since hitting a three-year low of $1.4814 on July 9. Against the euro too, sterling has recovered from 4-1/2 month lows struck on August 2.

Now fund managers say chances are waning that it can rise much further on robust UK data, given the BoE has pledged to keep rates anchored and policy accommodative.

"Sterling has run its course," said Daniel Loughney, portfolio manager at Alliance Bernstein, which has $445 billion of assets under management. "The data will disappoint and we think the rates market has priced in too much tightening."

FADING RALLY

As soon as the BoE issued its forward guidance, many investors took the view that rates would rise sooner than forecast.

The BoE said it would consider tightening when the jobless rate fell to 7 percent, and that this could take three years.

However, after persistently strong data, sterling overnight interbank average rates, which form the basis of lending to the wider economy, are pricing in a slim chance of a hike in the 0.5 percent bank rate as early as the first half of 2015.

The BoE acknowledged in the minutes of its most recent meeting that unemployment, which remains elevated at 7.7 percent, was falling faster than forecast.

While some economists say the BoE may have to revise its policy guidance, many remain cautious on sterling's outlook.

"So far the strong cyclical recovery in the UK economy is not translating into markedly lower unemployment rates," said Mansoor Mohiuddin, head of currency strategy at UBS. "We remain cautious about sterling/dollar strength."

In the options market, too, traders said enthusiasm for bets that sterling will gain much against the dollar was waning.

One-month sterling/dollar risk reversals, a gauge of demand for options betting on a currency rising or falling, show a bias for dollar strength, albeit much lower than it was in late August.

"There hasn't been much demand for upside strikes in sterling going into the GDP (gross domestic product) data," said a chief option trader at a large European bank. "The hedge funds are selling sterling into any weakness in data only to return to buy it at $1.60. It is too good a trade to ignore."

The buying on dips reflects a conviction that Britain is firmly on the road to recovery. But the rally from here looks likely to be more measured than that of the past few months.

"We think sterling will be sticky at higher levels and data surprises will be less positive," said Ken Dickson, investment director of currencies at Standard Life, who helps oversee $271.2 billion in assets. "We are neutral sterling/dollar."

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