Hedge funds have reduced their holdings of the British Pound (GBP) significantly due to concerns about the UK's fiscal position and declining demand for government bonds, known as Gilts.
According to UBS's FX Flow Monitor, hedge funds have sold an amount of GBP that is 3.1 standard deviations above normal in the past two weeks, marking the biggest flows since November.
Historical patterns suggest that after such intense selling pressure, the GBP against the US Dollar () often experiences some recovery. Data from the past five years shows an average rebound of 0.6% in the nine days following similar sell-off events for hedge funds.
However, the trend does not seem to last long, because usually, the GBP/USD starts to decline again, with an average drop of 1.4% from the ninth to the fifteenth day after the peak sell
UBS analysts also expressed a bearish view on the GBP, citing structural issues within the UK financial markets. The upcoming auctions for 30-year inflation-linked bonds (Linkers) and 10-year Gilts could further test investor confidence if demand remains low.
Additionally, the release of UK Consumer Price Index (CPI) data for December is on the horizon. A softer inflation reading could pave the way for a 25 basis point rate cut by the Bank of England in February, which could provide some relief to UK rates.
However, such a rate cut may not support the GBP, as it would reduce the currency's interest rate differential benefit. From a valuation perspective, a model based on the UBS regression shows that the Euro against the GBP () is still relatively cheap, with a z-score of 2.5.
UBS suggests that selling GBP for the Euro could be a strategic move to stop a short-term GBP/USD rebound.
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