Has Sterling's Bull Run Come to an End?

GBP fell against the dollar some 1.25% following Bailey’s remarks and we saw options traders continue to buy protection against a further decline in sterling, funded by selling upside participation. These structures, risk reversals, went from “calls over puts” in the month of August to “puts over calls” very rapidly – the markets’ way of warning investors which direction it deems most likely for the coming months. Market commentators also jumped on the band wagon, with prominent money managers calling for a 10% fall in the medium term.

Too Far, Too Fast

We believe the recent move in sterling has been an exaggerated one considering the major driver was Bailey’s comments. This was brought to light the day after The Guardian article, when BoE Chief Economist Huw Pill spoke to the Institute of Chartered Accountants. Pill warned against going “too far or too fast,” preferring instead to implement a “gradual withdrawal” of restrictive monetary policy. As one of the more hawkish members of the Monetary Policy Committee, Pill is concerned about the risks of more persistent inflation.

The BoE has drawn up three scenarios it believes could play out – inflation regulates naturally driven by pay growth decline and services inflation falling away; inflation falls but is driven by restrictive rates; and “deeper structural changes” keep inflation elevated longer than expected. Pill sees the second scenario as most likely, but is hesitant to assign too low a probability to the third.

Pill’s beliefs are well-founded. Whilst pay growth is regulating, with growth numbers falling back to mid-2022 levels, they still sit at 5.1%. This growth, far above target inflation, is coupled with unemployment figures still close to historic lows at 4.1%. Adding to concerns, services inflation is struggling to moderate – the most recent print saw the number climb to 5.6%. Whilst improvement is still needed in growth, it remains robustly positive (in contrast to Germany, for example), and the outlook remains tentatively positive. These factors indicate the BoE may need to maintain rates relatively restrictive whilst it ensures we are not amid a “deeper structural change.” When this “disappointment” feeds through to the FX market, we could see a new lease of life given to sterling.

Risks on the Horizon

Several risks loom on the horizon, both domestic and international. Closer to home, the upcoming UK Budget presents a potential challenge. While the exact details remain uncertain, tax hikes and some spending moderation seem almost certain to be on the agenda. The details of this will no doubt be a driver for UK growth prospects in the coming months and years.

Internationally, tensions in the Middle East continue to escalate, posing a significant threat to global stability. European dependence on oil from the region is well known, and disruptions to this supply would be detrimental to growth and the fight against inflation. The US is comparatively energy secure, so one could easily see the dollar benefit at the cost of sterling and euro. In the markets, positioning in GBP is also becoming stretched, with long positions reaching levels not seen since 2018. The bullish sentiment has undoubtedly contributed to the recent rally, but from here additional marginal buyers may be hard to come by and there could be further fast unwinding of positions if we see negative headlines.

Volatility is set to continue in sterling for the coming months, driven by a confluence of factors. The path forward is likely to be anything but straightforward. Those exposed to fluctuations in sterling would be well advised to consider their positioning now ahead of a busy end to the year.