This analysis is by Bloomberg Intelligence Chief G10 FX Strategist Audrey Childe-Freeman. It appeared first on the Bloomberg Terminal.
Adjusting to outright bullish sterling views still faces obstacles, in particular near-term cyclical headwinds, but this is arguably yesterday’s narrative and the path to better sterling fortunes is emerging and could tempt via options. The unfolding of our broadly weaker dollar outlook in a risk-on market context, if confirmed, would help pound believers in 2024.
Selective sterling upside via options?
Identifying and timing highs and lows in currency pairs is always challenging, but the price action is always telling and sterling’s recent moves have been promising, we believe. Much negative economic news is priced in and — while we acknowledge the news flow could get worse before it improves — the outlook’s risk-reward may be evolving toward a positive outcome. This at a time when dollar sentiment has started to turn, with associated sterling-dollar upside. Options strategies may offer ways to avoid the issue of timing, with three- and one-year sterling call options turning more positive already.
Three-month and one-year risk-reversals on sterling-dollar have pushed to minus 1.3675 and minus 0.6375, respectively, from lows near minus 2.50 and minus 1.84 in January.
Think sterling upside? Dollar, loonie?
An FX options strategy has merit, but so does being selective with a bullish pound view at this early stage of a potential recovery. If you believe in broad, near-term dollar underperformance, as we do, you must acknowledge the loonie — the ultimate proxy for the greenback — is exposed too. On top of that, signs of a weakening Canadian economy, and any dovish Bank of Canada yield adjustment associated with that, could add to the bearish loonie view early next year.
Sterling-dollar may test $1.25 sooner rather than later and sterling-loonie could break 1.70 again, with further near-term resistance seen near 1.7343 — 2022’s high. The pair has already regained almost 4.5% from its October low below 1.64.
Confirmed risk-on would boost pound bulls
Sterling’s high-beta status was validated by the recent price action, with undershooting US inflation data and the subsequent dovish adjustment in Fed rate expectations boosting risk appetite — take the S&P’s rally as a proxy — and the pound. It’s premature to assume that US rate cuts are imminent, in light of recent Fed comments. However, to the extent that softer US data help global risk appetite via more-dovish rate views, that could contribute to fresh sterling-dollar upside, with a break of $1.25 back in the cards.
Between late October and Nov. 14, the S&P had recovered over 9%, with sterling-dollar appreciating by about 3.25% over the same period.
Economic performance: Poor but priced in
Sterling’s 1H outperformance was partly due to a surprisingly resilient UK economy, but there’s mounting evidence monetary tightening is feeding through. Q3 GDP growth was flat, implying a recession has been averted for now, but the picture’s not clear for 4Q and into 2024. In particular, the consumer sector will be more exposed as the contribution from excess savings fades. In theory, this isn’t especially supportive for the pound, given our working assumption that growth differentials will drive FX more next year but, in practice, poor economic news is fully priced in — unlike for the US — so to what extent this drives sterling lower is questionable.
Bloomberg Economics forecasts UK GDP growth of 0.4% this year and minus 0.7% for 2024.
Pound strength doesn’t need hawkish BOE
BOE easing may be off the table for now, but the view that rates have peaked makes sense and isn’t overly negative for the pound. In the first place, rate-peak debates aren’t UK-specific, so if we assume they’ve also reached their highest levels in other nations, relative yield differentials won’t change much in the near term. We also believe that, in 2024, growth differentials could become more of a currency driver than nominal rates and if a less-hawkish BOE helps the UK economic narrative improve (more so in 2H), it should aid sterling too.
As of Nov. 14, Bloomberg’s WIRP <GO> function priced in the first BOE rate cut by 2Q24, which is earlier than Bloomberg Economics’ working assumption for 3Q20.
