Why the British Pound Sterling is likely to overreact to good-news

Late Friday May 31 the CFTC released positioning data for IMM participants as of the close of Tuesday May 28.

That data shows the positions of various types of IMM clients, but the clients I focus on especially is leveraged funds.

This group is of particular interest because it is the least likely to be hedging positions in other markets and is most likely to have a relatively nearby stop.

In general, the positions of this category of FX market participant is consistent with price trends. The story becomes particularly interesting when that is not the case, or when positions get exceptionally large relative to history.

There are two currencies where IMM leveraged fund positions are close to historical maximums. They are AUD and GBP.

For AUD, the USD equivalent value of IMM leveraged funds’ short side is 7.0bn. That is just shy of a previous record of 7.1bn. Leveraged funds’ long side is

USD5.1bn worth, so their net position is short by 1.9bn. I don’t consider this to be anything near to limit short, but it is a noteworthy departure from the norm of the past five years. FX markets have almost always been long-AUD over that period.

In GBP, IMM leveraged funds are holding a short side worth USD11.2bn. This is close to the previous record of 11.8bn. With longs worth only 3.4bn, the net position is short by 7.7bn. This is close to a record short for the net as well. The previous record net short is USD8.5bn. Again, I wouldn’t consider the short position in GBP as being limit short here, but the short is big enough that the market is likely to have a somewhat asymmetric reaction to news. Bearish news will probably push GBPUSD gently lower, while GBP-bullish news runs the risk of triggering an outsized rally due to cascading IMM stops.

The story in CAD is a particularly interesting one. The net short-CAD position of IMM leveraged funds has continued to shrink. As of Tuesday’s survey it was just USD3.8bn, which is les that half of the 8.5bn net short recorded on April 16. One would expect such a trimming of positions if the market were trending against the position of IMM leveraged funds. However, markets have continued to trend in favor of prevailing positions, which normally prompts investors to increase them.

My interpretation of what is going on here is that leveraged funds have given up on this trade because they don’t understand what is driving it and don’t trust their models.

However, if USDCAD establishes a foothold above 1.02, I expect IMM leveraged funds and other similar FX investors in the OTC market to re-build their long USDCAD positions to the size they were at six weeks ago. I believe they will likely drag USDCAD through 1.05 as they rebuild.

The other pair where markets continue to wonder about positioning is USDJPY. I admittedly don’t think IMM leveraged funds are a good proxy for the broader market in USDJPY because their style is not representative of Japanese participants, but for full disclosure I will note that positions are middle of the road.

The short-JPY side did grow a bit in the last survey to USD12.6bn worth, but that is still far away from the max for that side of 18.bn in early March. The net short-JPY (long USDJPY) position of 7.9bn is barely more than half of the 13.0bn net short-JPY position in late December.