By Naomi Rovnick
LONDON (Reuters) -It's the best performing currency this year in the G10 group of advanced economies against the dollar. But sterling's strengthening streak is about to be put to the test as a succession of rate hikes heighten worries about growth.
Britain's pound, at around $1.251, on Thursday edged back from recent one-year highs against the dollar, having been driven higher partly by expectations that U.S. rates will fall later this year while UK borrowing costs climb.
On Thursday, the Bank of England lifted interest rates for the 12th successive time, to 4.5%. But in a sign that optimism is fading out of the long-sterling trade, the pound swooned 0.9% lower in the hours following the BoE's decision.
Investors are now focusing less on predicting U.S./UK interest rate differentials and moving towards a view that sterling will weaken as rate increases drag on the economy, even though the BoE on Thursday dropped its forecast of a recession.
"While the dollar "could have another leg down," as the U.S. at least pauses policy tightening, in the case of sterling, "you don't want to chase this much further", said Barclays (LON:BARC) global head of FX strategy Themos Fiotakis.
The pound has risen about 3.5% against the dollar so far this year and is up some 17% from lows hit in the wake of September's disastrous mini-budget.
Deutsche Bank (ETR:DBKGn) said on Wednesday it no longer thinks the British currency is attractive in the short-term.
According to money market pricing, the Federal Reserve has come to the end of its most aggressive rate-hiking cycle in decades and will soon start cutting rates as U.S. recession risks grow. Those expectations are already baked into how the dollar is trading against competing currencies.
After Thursday's BoE rate decision, markets priced UK rates to peak at around 4.8% by November.
Interest rate differentials are a key driver in currency markets, but some analysts said the gap between U.S. and British borrowing costs were just one part of the story.
Sterling has also been boosted by greater than expected resilience in the domestic economy and hopes that China's rebound following the relaxation of stringent coronavirus curbs will prove positive for European growth.
But that Chinese boom has not yet transpired, making it harder for sterling bulls to hold onto their trades, said Barclays' Fiotakis. Speculators hold a net long position in sterling worth $80 million, having been short to the tune of as much as $6.3 billion a year ago.
China's factory activity unexpectedly contracted in April, data last week showed.
Fiotakis has a price target of $1.28 for sterling, suggesting further gains would be limited to a rise of around 2%from current levels.
RECESSION RISK
After 440 basis points worth of rate hikes in this cycle, analysts said BoE tightening was nearing an end and increasingly likely to show up in a weaker economy ahead.
"We do not expect more hikes," said Laureline Renaud-Chatelain, fixed income strategist at Pictet. "We expect the UK to fall into a recession in the second half of the year."
The International Monetary Fund expects the UK economy to shrink by 0.3% in 2023, less than an earlier forecast for a contraction of 0.6%.
Craig Inches, head of rates and cash at Royal London Asset Management, said the outlook for UK inflation, running at 10.1%, was complicated by still-high wage increases amid a worker shortage linked to Brexit.
He added that rate-setters probably hoped to "sit on their hands as long as they can because they know that large base effects are going to bring inflation down".
Eugene Philalithis, head of multi-asset-investment management for Europe at Fidelity International, who also expects a UK recession, said he was negative on sterling against the euro and yen.
The European Central Bank lifted rates a week ago and has flagged further increases after starting to tighten later than its major peers. Sterling, flat against the euro on Thursday, stuck close to a five-month high.
The Bank of Japan is widely expected to end its controversial policy of buying up huge quantities of government bonds to suppress domestic borrowing costs, in a move that is likely to strengthen the yen.
Noting that sterling has delivered the best volatility-adjusted returns in the G10 this year, Deutsche Bank strategist Shreyas Gopal said "we no longer think the pound presents attractive risk-reward in the short term".