Hedge funds caught short when Brexit talks surprise

By Tommy Wilkes and Tom Finn
Britain's Secretary of State for Exiting the European Union Dominic Raab arrives at 10 Downing Street in London, Britain, October 24, 2018. REUTERS/Henry Nicholls

By Tommy Wilkes and Tom Finn

LONDON (Reuters) - British Brexit minister Dominic Raab's "thumbs up" after a cabinet meeting on talks with the European Union was all sterling needed to jump nearly half a percent last Tuesday.

A story buried on the 14th page of the Times newspaper at the start of November about Britain and the EU sealing a deal on financial services sent the pound to its biggest one-day rise since mid-2017, despite repeated denials from both sides.

With negotiations between London and Brussels for a divorce agreement entering the final stretch, hedge funds have such large bearish bets on sterling that sudden positive news - no matter how incremental - is having a dramatic impact on the currency.

That means that big jumps in sterling may reflect investor positions rather than outright confidence of a deal. It also means that the pound has the potential to rally hard if an agreement is confirmed.

"A little glimmer of good news and the pound shoots up. You get some pretty substantial bad news and cable (the pound versus the U.S. dollar) doesn't really move," said Neil Jones, head of hedge fund sales at Mizuho bank.

Since its dramatic drop after the Brexit referendum in June 2016, sterling has become the principal gauge of sentiment in financial markets towards Brexit ahead of the departure date in March.

In the week ending Nov. 9, hedge funds hiked their bets against the pound by more than $800 million, bringing the outstanding net short position in sterling against the dollar to $4.65 billion <GBPNETUSD=>, Commodity Futures Trading Commission data shows. That is down from a 2018 peak of $6.5 billion hit in late September - the highest since May 2017 - but still a sizeable amount, according to the data, which captures a small part of overall investor positions in an opaque market.

For the many traders positioned against the pound, that means any good news can leave them scrambling to cover against more losses, exacerbating the move higher.



As Brexit brinkmanship builds, there is also the small but growing chance of a second referendum - an outcome analysts say should boost the pound because it increases the possibility of Britain remaining in the EU.

Investors began to ramp up short positions versus the British currency in April when the Bank of England skewered expectations for an imminent interest rate rise.

They piled on those negative bets from July onwards as fears rose that Britain and the EU would not agree divorce terms - leading to a disorderly Brexit and serious damage to the UK economy.

Investors have struggled to make money trading the pound in 2018, and many funds have sat on the sidelines - cutting their holdings and shying away from betting on the ins and outs of negotiations that conclude with a binary, hard-to-predict outcome.

Highlighting the uncertainty, a Reuters poll published earlier this month found sterling would rise to $1.35 if Britain and the EU clinched a divorce deal, but sink to $1.20 without an agreement.


MORE SHARP SWINGS

Investors' overall position, though, is heavily short, according to the CFTC data and bank currency traders.

Sterling's trade-weighted index <GBPTWI=BOEL>, which measures the value of the pound against its trading partners, is trading 16 percent below its 40-year average.

That means should the Brexit negotiations turn positive, sterling could look cheap on one measure of its long-term value.

Currency traders are expecting sharper swings in the price of the pound over the next month <GBP1MO=> than at any time since January 2017 as the crunch date for hammering out a deal - and then getting it through British parliament - nears, derivatives markets show.

Since Aug 1, the average daily move in the pound has been large - around 0.4 percent - with slightly more negative days than positive ones, underlining investor nerves.

The market's view on sterling over three <GBP3MRR=> to six months <GBP6MRR=> is near its most negative since shortly after the 2016 Brexit vote, options markets indicate.



"The history of these negotiations suggests caution against trading headline risk as we believe confirmation of a deal and subsequent Parliamentary approval will provide the opportunity to participate in significant sterling upside," said Kamal Sharma, Bank of America Merrill Lynch's FX strategist.


(Additional reporting by Saikat Chatterjee; Editing by Toby Chopra)