Sterling poised to divide traders beyond key BOE meeting

London

ONE crucial Bank of England (BOE) meeting may not be enough to decide the debate between pound bulls and bears. The currency market remains divided on sterling after a month of being whipsawed.

While bearish sentiment reigns in options, indicators of volatility and positioning suggest a more benign outlook heading into the BOE's November rate decision.

"The signals will be really mixed, if you look at it from a currency playbook," Viraj Patel, macro strategist at Vanda Research, said of this week's central bank meeting. "The bar for the BOE to communicate a tightening cycle that's more aggressive than what's already priced in is really, really high."

The stakes for the meeting have risen in the past month after money markets ramped up bets for more than 100 basis points of policy tightening over the next year. While the pound has gained more than 2 per cent in the past month, longer-term sentiment has been weighed down by concerns that growth will suffer if the BOE delivers rate hikes as rapidly as traders expect.

These worries suggest that even if the central bank offers some clarity on the near-term path of monetary policy, the outlook for the pound may remain cloudy until traders get a better sense of how the economy will shape up amid any tightening.

The pound has been stuck in a downtrend since June, though it has rebounded 1.5 per cent in October and momentum has turned more positive. The line in the sand may be US$1.3850 - if sterling closes about that level, it would confirm a medium-term base is in place. Failure to do so could pave the way for bigger declines.

Of course, key for sterling's direction is its relationship with bond yields, which broke down in October. While yields have risen in response to expectations for policy tightening, sentiment on the pound - as measured by one-year risk-reversal rates - has gone the other way and shows traders are the most bearish this year.

The investing community is equally divided on the pound. Hedge funds and other leveraged accounts continue to bet on gains, though they have trimmed that position for four of the past five weeks, according to data from the Commodity Futures Trading Commission.

Meanwhile, institutional money managers flipped to bullish from the biggest net short in two years seen earlier in October. After speaking with hedge funds, real money investors, banks and corporates worldwide, Credit Agricole has found that not a lot of clients hold a short position on the pound because of the positive carry, according to strategist Valentin Marinov.

Money managers at William Blair and Aberdeen Asset Management were among those who turned neutral on the pound in recent weeks, citing uncertainty over the growth outlook. Strategists, meanwhile, see sterling stuck around current levels. Their median year-end forecast is now US$1.37, down from as high as US$1.43 four months ago.

The pound's one-week implied volatility - or the cost of hedging against swings in the currency - remains below the year-to-date average even with rate decisions due from the BOE and the Federal Reserve, as well as US employment data.

Yet it's the most expensive since March when compared with realised volatility.

That aligns with measures that show traders have grown more bearish on the pound in the past month. BLOOMBERG