Interest rate cuts meet global market turbulence, the road to pound appreciation is blocked

After the British Labour Party won the election, the pound started its upward trend. However, now, as pressure mounts, forex traders are looking for reasons to remain optimistic. Following the Bank of England's first rate cut since 2020 earlier this month, investors have turned cautious on the pound, but they did not anticipate the impact of weak US data and volatility in the Japanese market on the pound. In the UK, anti-immigrant riots and the prospect of tax hikes have dampened post-election optimism and exacerbated the pound's decline from its one-year high. Currently, the pound has fallen over 2% from its one-year high against the US dollar to around 1.27.

Shahab Jalinoos, Global FX Research Director at UBS, said, "The honeymoon period for the Labour Party may be over. The pound has finally reacted to what seemed like overly long positions for some time."

Hedge funds, asset management companies, and other speculative market participants pushed net long bets on the pound to historic highs in July, betting that the political landscape would calm down after Keir Starmer took office. Institutional investors, including Amundi SA and Loomis Sayles, expect a change in government in the UK to bring stability and boost the economy. These crowded derivative positions have now fallen to their lowest level since April. The pound is the worst-performing currency in the G10 in August, threatening its best performance of the year.

The optimism surrounding UK politics has faded. Riots led by far-right activists are gradually becoming a major issue in the early days of Starmer's tenure. Lauren van Biljon, portfolio manager at Allspring Global Investments, said, "The pound was once a stable currency in Europe. Perhaps in the long run, the protests of recent weeks have weakened this."

Van Biljon stated that the turmoil in the UK, coupled with widespread market turmoil globally, indicates that the pound cannot dominate like the US dollar. She said that the role of the dollar as a global safe haven asset means that even during periods of uncertainty in the US, the dollar can appreciate.

After Japan raised interest rates last Wednesday, while the Bank of England cut rates, the pound became vulnerable to sharp adjustments in the forex market. This has diminished the pound's relative advantage as it limits the potential returns for investors investing in pound-denominated assets. Paul Mackel, Global Head of FX Research at HSBC, said, "The pound cannot escape the influence of these global forces. The pound is like a castle built of sand, its superficial resilience will soon be washed away." The stock market has also reversed what was seen as an optimistic trend by investors towards the new government: tracking the FTSE 250 index, which represents the UK domestic stock market, is no longer outperforming the FTSE 100 index, which has a higher export component. However, the weakening of the pound brings a glimmer of hope that it may boost corporate performance, as corporate profits are often negatively correlated with the pound exchange rate