Time for a Pound Sterling Short-Squeeze

The British Pound is at risk a of sudden turn higher which could wrong-foot those betting againts the currency.

Markets are heavily leveraged against Pound Sterling with latest CFTC IMM data showing that bets against the currency remain near their highest levels since 2013.

This explains why the longer-term trend in GBP remains tilted lower.

However, often such crowding can be prone to shakeups.

The Pound is in danger of suddenly shooting higher versus the Dollar in the short-term, due to an excessive balance of bets against Sterling argues Richard Kelly, global head of strategy at TD Securities.

“Overwhelmingly bearish short positioning,” writes Kelly, "could result in a panic unravelling of short bets, if the pair suddenly reversed its course and started going higher."

Such reversals are called a ‘short-covering rally’ or ‘short squeeze’.

A short squeeze is normally a very rapid rise in a security which has been trending lower for some time before suddenly reversing.

Sterling Positives

TD Securities highlight several bullish factors for the Pound which hints at the prospect of a more sustained recovery.

Third quarter growth, for example, is set to rise well above previous expectations.

“UK data covering the summer months has caught most forecasters off-guard. Early forecasts for the post-referendum third quarter expected growth to be flat or negative as confidence fell and uncertainty spiked up. But in the wake of the vote, activity has outpaced expectations,” notes Kelly.

From initially forecasting 0.1% growth in Q3 back in August, the BOE revised that up to 0.3% in September and NIESR’s (National Institute of Economic and Social Research) estimate in October was 0.4%.

“The Q3 strength has come as consumers looked through Brexit anxiety, Indeed, on 24 June, nothing actually changed in the UK. For 17.4 million Britons, this is exactly what they voted for. And despite the near-20% depreciation in the currency since November 2015, consumer prices have yet to be notably affected. Against this backdrop, households continue to spend,” writes Kelly.

Another possible source of strength for the pound is the Autumn budget statement, which is widely expected to show a rise in public spending and activities which stimulate the economy fiscally.

Chancellor Hammond has already said he will scrap the 2020 target for balancing the budget, taking pressure of cost cutting and austerity.

A fiscal boost would be positive for the pound as it would take the pressure of the BOE to have to use more monetary stimulus.

Theresa May herself said she was not in favour of low interest rates and that her government was going to change things, which hints at the government taking over more responsibility for promoting growth away from the BOE.

Kelly also notes that passporting rights for financial services companies may not all be lost in the event of a Hard Brexit.

“Passporting rights remain a separate issue, and if the UK maintains EU financial-sector standards, it could achieve 'Super Equivalence' status in some areas of the finance sector (though notably not Insurance), allowing parts of its financial sector to continue passporting into the EU regardless of broader Single Market access issues.”

This too might lessen fears about the future of the City.

Finally, the recent bounce in Gilt yields, which surged from lows of almost 0.5% to 1.0% is likely to provide a filip for the pound.

Although the exchange rate is highly correlated to 10 year yields, it did not properly mirror the jump which occurred, suggesting a delay before the exchange rate rises.

Eventually, however, it would be expected to gain a boost from the jump in yields.

Factors against Sterling

Negative’s for the pound are still considerable.

Kelly suggests the BoE may look past all the positive data and take a more pessimistic longer-term view incorporating the period after a complete Brexit.

“16Q3 data has surprised significantly to the upside as a drag from lower confidence failed to materialise, but the Bank of England is no longer as data-dependent as it used to be. The MPC is focused on the medium-term now.”

He also points to the high number of business surveys conducted by the bank itself which show sentiment still falling in relation to the impact of Brexit on the economy.

Worst of all for the Pound is the increasing probability that Brexit will be complete, unambiguous and ‘Hard’.

“While there remains little concrete view of post-Brexit Britain, some clarity is starting to emerge. A Department for Brexit (DEXEU) spokesman announced four key goals for the UK outside of the EU: no free EU migration, no contributions to the EU budget, supremacy of UK courts, and supremacy of UK laws.”

It is with this in mind that TD’s Kelly eventually comes down on the side of expecting a rate cut in November and therefore further weakness from the Pound over the medium-term.

Overall TD retain their end of year forecast of GBP/USD at 1.20.

Our view is that considering the high chance of a fiscal programme making up for a lack of monetary stimulus, and the prime minister’s aversion to QE and lower interest rates, there is also a fairly considerable possibility the bank may also stand pat.