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  • Leveraged funds have turned more bullish on the pound by increasing their net-long positioning. However, asset managers remain stubbornly net short the pound.
  • We side with asset managers. The pound is unlikely to outperform the U.S. dollar given we think BoE will deliver a larger cutting cycle than the Fed. CME Group data on option strikes suggest markets are weighted to downside over upside, too.
  • The FX volatility curve using CME Group options data suggests investors are nearing “fear/panic” mode.

The pound has been trending higher since late October as the UK failed to fall into a widely anticipated deep recession. The labour market hung on, while inflationary worries abated. Meanwhile, the Federal Reserve delivered a sequence of dovish surprises, leading U.S. yields and the dollar lower. Markets reacted aggressively but are now uncertain on what follows.

Leveraged funds are yet to doubt this rally. Trading at 1.2750, they have closed 23.0k short positions over the past month, leading to a 21.8k increase in net longs (Chart 1). No other currency has seen such a large revision over the period.

However, asset managers are unconvinced. They increased their already net-short positioning on the pound over the same period (Chart 2). As a result, asset managers are only in a larger net short in the Australian dollar, with all other net shorts pared or flipped to net longs.

Macro Hive take: The next one-to-three months are tough to call for the pound, especially against the U.S. dollar. Both the BoE and Fed are expected to cut rates. However, we think the Fed are likely to cut with political motivations, while the BoE will cut due to a sluggish economy. That will leave the latter delivering a larger cutting cycle. Given the already strong move in the pound, we expect GBP/USD will, at best, maintain current levels in coming months.

Option strikes

Investors see limited GBP/USD upside. According to CME Group data on option strikes:

  • There is net demand for GBP/USD calls from 1.27 onwards (Chart 3), with demand strongest at 1.29. However, net demand quickly weakens thereafter.
  • In contrast, bearish demand pushes convincingly down through 1.20 and lasts until 1.15. That is a 10% decline from current levels.

What to watch: Further pound upside relies on the market pricing out BoE cuts. Markets currently expect the first cut by June at the latest. Next week is important as it contains the December CPI print. Inflation fell strongly short of expectations through November; the same again would likely leave market pricing surer of an earlier cut. It would also prompt a more dovish tack from the BoE on 1 February. This would dent hopes for pound upside.

FX investor risk appetite

CME Group has a range of FX volatility data to help investors track the level of volatility. We can also use FX volatility data to determine investor risk appetite. We find the shape of the FX volatility curve useful in this regard. When shorter-dated FX implied volatility is higher than longer-dated volatility, this suggests investors are worried or in panic mode. In contrast, when shorter-dated FX volatility is lower than longer-dated volatility, this suggests investors expect calm markets. The latest data finds:

  • The FX volatility curve is unwinding its yearend flattening (Chart 4). We are nearing a steep curve. This suggests investors are becoming more certain central bank cuts are coming, but even more uncertain on what will happen thereafter.
  • The move aligns with the CME Group CVOL volatility indices, which have followed a similar dynamic, trading near year lows.
  • Outside FX, equity volatility remains historically low, while rates volatility remains historically high.

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