Pound rally puts currency at risk of selloff after a trade deal

The pound’s best days may be behind it, even if the U.K. and European Union sign a trade deal.

The relative cost of hedging against a weaker sterling through year-end is the highest since April, according to a gauge of positioning and sentiment. And over the past month, hedge funds and other leveraged funds have increased short bets against the currency, data by U.S. Commodity Futures Trading Commission show. Meanwhile, the currency rose to $1.3416 on Thursday, just shy of the highest level in a year.

Some investors are still holding out for a payday when a trade agreement is signed, others are looking further out and say the U.K.’s economic outlook seems grim. For TD Securities, the damage the coronavirus continues to inflict on the nation’s domestic output—which is more vulnerable now that the transition period from the EU is almost over—is hurting the pound’s prospects. JPMorgan Chase & Co. estimates the currency will settle in the low $1.30s after the U.K. and EU strike a deal.

“The optimism around Brexit itself is fully priced in and a little too optimistic relative to where we go in the next couple of weeks,” said Mark McCormick, the global head of foreign-currency strategy at TD Securities. The investment bank’s 2021 outlook recommends selling the pound if an accord is signed.

Sterling had its best November since 2006, buoyed by the U.S. dollar’s drop and encouraging rhetoric from both the U.K. and EU on the possibility of a trade agreement. It rose to as high as $1.3441 this week despite suffering one of the biggest economic slumps among developed nations in 2020.

And while the likes of Jack McIntyre, a portfolio manager at Brandywine Global Investment Management, is bullish on the pound in the hopes that Brexit will help the U.K. unleash its “animal spirit,” risk reversals and positioning data suggest otherwise.

If there’s a trade deal, “we accept the possibility that GBP could overshoot by a couple of cents, call it 1.35, but we see little value owning GBP for what could be a very-bounded, and potentially short-lived, relief-rally,” Paul Meggyesi, JPMorgan’s head of global foreign-exchange strategy, wrote in the bank’s 2021 outlook.

Economic Cost

Not only has the pandemic put Britain on course for its deepest economic slump since the Great Frost of 1709, the Office for Budget Responsibility estimates that the loss of output could be permanent.

Even if the U.K. enters a free-trade agreement with the EU, 4% would be shaved off the nation’s gross domestic product in the long run compared to where the economy would’ve been if Brexit never happened, the OBR forecasts. Failure to reach a deal, which means adopting World Trade Organization rules, would entail another 1.5% loss in GDP.

Brexit isn’t “favorable for an economy that hasn’t fared well through a pandemic,” McCormick said.