Sterling’s gains against its peers got a fresh boost this week, but strategists at JPMorgan Private Bank, State Street Global Markets and Jefferies say those gains are looking increasingly fragile.

The Bank of England's decision on Thursday to keep interest rates unchanged after the Federal Reserve's sharp rate cut the day before sent sterling to its highest level against the dollar since March 2022. Sterling has been the best performing currency among the Group of 10 major economies this year, and bets on its further strength are already near their highest in a decade.

GBP leads G10 currencies this year

But weak economic growth in the first half of the year and the prospect of a tighter Labour budget in October mean the outlook for sterling is clouded as it increases the likelihood that the Bank of England will need to speed up its pace of rate cuts to protect the economy, while also removing a key pillar of support for the pound.

“I think the pound is living on borrowed time,” said Tim Graf, head of EMEA macro strategy at State Street. “Ultimately, I think GBP/USD will be lower in three to six months.”

The Bank of England’s gradual approach to rate cuts, as other central banks accelerate their pace of easing, means being long sterling has become a crowded trade for investors seeking higher relative returns.

Long positions in sterling held by hedge funds and other leveraged funds are hovering near their highest levels since 2014 after surging in July, according to positioning data from the U.S. Commodity Futures Trading Commission. Institutional investors have become more bullish on the pound than at any time in a year over the past month.

Sterling was trading around $1.33 on Friday, but analysts at HSBC said the strength was "unsustainable".

Nick Andrews, senior currency strategist at HSBC, said the Bank of England would need to cut interest rates by 225 basis points by the end of 2025, while the market was pricing in 150 basis points. He said the pound's gains would be challenged as investors gradually readjusted their expectations for the prospect of further rate cuts.

Matthew Landon, global market strategist at JPMorgan Private Bank, said that while the current slow pace of rate cuts in the UK has made the pound a top choice for investors seeking higher yields, "there is little point in chasing these gains in the short term."

To be sure, so-called risk reversals - a barometer of market positioning and options sentiment - suggest the market is more bullish on sterling over the coming month, even as the trade has become more crowded. Traders say demand for British assets persists after the new government took office.

“Typically, the convergence of spot and options markets suggests that the current trend makes sense,” said Vassilis Karamanis, a currency strategist at Bloomberg. “Until the market changes direction, or at least there is a divergence between spot and options traders, demand for UK assets should increase further. When money flows, it’s best to respect price action, no matter how crowded the trade is.”

But chasing the pound higher could be troublesome in the long run.

With sterling near its highest level against the euro in two years, hedge funds have been taking protective positions in the options market, according to currency traders familiar with the trades.

Sterling is already trading about 2.5% above $1.30, the median price target for the currency by the end of the year according to strategists polled by Bloomberg. While it’s possible that the pound could rise to $1.35 in the coming weeks, Brad Bechtel, global head of foreign exchange at Jefferies in New York, said he was “cautious” about further gains.

“There may be a little bit of upside in GBP/USD, but not much,” Bechtel said.

The tax increases and spending cuts that some are calling an "austerity budget" due in Britain next month are also not expected to help the economy in the short term.

Stephen Jen, chief executive of UK hedge fund Eurizon SLJ Capital, said this could prompt the Bank of England to accelerate the pace of rate cuts to cushion the demand shock while hurting the outlook for sterling.

The article is forwarded from: Jinshi Data