Analysis-British Pound: The sick man of the currency world

By Saikat Chatterjee

LONDON (Reuters) - In volatile currency markets, one trade stands out as an easy bet: selling the British pound.

With the world's fifth-biggest economy grappling with a particularly unhealthy cocktail of slowing growth and surging inflation, the British currency has become the medium of choice to express a negative view. Official data on Wednesday showed inflation reached a 40-year high of 9% in April - more than four times the Bank of England's 2% target while Britain's worst cost of living crisis in three decades will not subside until late this year, according to a Reuters poll.

And though the BoE was the first among major central banks to raise interest rates in December, now their predicted future path is far less steep than some of its global peers including the U.S. Federal Reserve.

While the British economy's problems are broadly similar to what other policymakers are grappling with, a few unique factors additionally weigh on the pound.

One is the potential for a messy trade conflict with the European Union if Britain threatens to push ahead with a law to override parts of a post-Brexit trade deal for Northern Ireland.

Any protracted trade war would threaten to further widen the current account deficit and subsequently weaken the currency. Then there is an increase in tax burdens, which followed massive temporary relief for struggling sectors during the pandemic and which has hit workers and employers already saddled with surging energy bills, adding to the drag on the economy. "The chance of a UK recession is all but guaranteed as there are just too many headwinds facing the economy," said Wouter Sturkenboom, chief investment strategist for EMEA and APAC at Northern Trust (NASDAQ:NTRS) Asset Management. Money markets now expect only 120 basis points of cumulative rate hikes by the end of the year compared to the Fed's nearly two full percentage points. Even a more cautious European Central Bank is expected to raise interest rates by 108 basis points over that period.

Jane Foley, head of FX strategy at Rabobank says markets have slashed their UK rate hike expectations in recent weeks because recession risks have grown. Respondents in a Reuters poll assign a 35% probability of a recession within a year.

Kaspar Hense, a senior portfolio manager at Bluebay Asset Management in London, said he was short the currency in his portfolios.

"The pound has the weakest outlook among all the major currencies as the central bank's reluctance to raise interest rates aggressively means it has the lowest inflation-adjusted yield among its rivals," he said.

As the war in Ukraine added more fuel to price pressures, UK growth expectations and consumer confidence tumbled because of the soaring inflation, the protracted conflict and concerns about the impact of extended COVID lockdowns on growth in China, Britain's third biggest trading partner.

Citibank indexes that measure how economic data fare compared with expectations are lower for Britain than for the rest of Europe or the United States, suggesting growing economic headwinds ahead.

TURN FOR THE WORSE

That suggests any British rate hike cycle will be short-lived. Using the spread between three year and 1-year market interest rates, HSBC strategists predict interest rates will peak in June 2023, rising to 2.5%, and then rate cuts will follow.

"The consumer outlook has taken a big turn for the worse, as the real income squeeze bites hard and this will make it very difficult for the Bank of England to deliver anything close to what is priced into the forward rates market," HSBC said.

HSBC now expects the pound to end the year at $1.20, some 8% weaker than its earlier $1.30 forecast.

On Wednesday, the pound was trading at $1.24, down nearly 8% so far this year and not far from a May 2020 low of below $1.21 touched again last week.

The British currency's transformation into a poster child of the stagflation risks facing the global economy has been swift.

In early December, hedge funds still were still betting against the dollar and favouring the pound. Six months later that has completely flipped to the biggest short pound bet in more than 2-1/2 years. The outlook remains bleak. Three-month British pound risk reversals which measure a ratio of sell to buy options are at one-month highs while expected price swings are holding near two-year highs.