By Saikat Chatterjee
LONDON (Reuters) - Sterling investors remain hesitant about chasing the rallying pound higher even as the British government said it was close to an agreement with the European Union on how to move Brexit talks onto trade next year.
British hopes of securing a deal with the European Union were dashed on Monday by Prime Minister Theresa May's kingmakers in Belfast. The government is holding fresh talks and said on Tuesday it remained confident of reaching an agreement.
After spending most of 2017 on the back foot against a broadly weak dollar, market expectations on sterling have shifted considerably in recent weeks towards betting on a breakthrough in Brexit negotiations with the British currency <GBP=D3> rising to more than a two-month high last Friday.
High-frequency indicators of market positioning and options market hedging have also shifted markedly to show green shoots of optimism emerging.
Speculative bets on sterling, shown in data compiled by the U.S. Commodity Futures Trading Commission and often seen as a proxy for hedge fund positioning, outweighed those betting on a fall in sterling for the first time since the Bank of England raised interest rates in early November.
Prior to that brief pre rate rise flurry, there had not been a net long position in sterling since October 2015.
What's more the cost of one-month options to buy sterling in the derivatives market exceed that of options to sell it for the first time since October 2017.
But despite sterling's bounce in recent days, investors remain wary about the currency's outlook pointing to the long complicated negotiations before Brexit becomes a reality in 2019 and the underlying weakness of the British economy.
"There is still a lot of work to be done before we get any clarity and to take big positions in this headline-driven market is fraught with dangers," said James Binny, head of currencies at U.S. financial group State Street Global Advisors in London.
So despite a cautious return in long sterling bets in the currency markets, the duration of those positions have become shorter, indicating how nervous markets are.
So far, these net sterling long bets are only a week old, compared to in October which remained for a month. The longest duration of long sterling bets was for a year between Sept 2013 to late 2014, according to CFTC data.
At the heart of this nervousness is a view that any Brexit outcome, either "soft" or "hard", will weigh on the economy at a time when other major world economies such as Europe and the U.S. are firing on all cylinders.
"The key issue for sterling is that from an economic standpoint it looks tough and any bounce after a Brexit talks breakthrough will be a buy-the-rumor and sell-the-fact trade," said Richard Benson, co-head of portfolio investments at Millennium Global Investments Ltd in London.
Annual growth forecasts will average 2.4 percent this year and 2.2 percent next year across the 19-member eurozone currency bloc compared with UK growth of 1.5 percent in 2017 and 1.2 percent in 2018, according to OECD forecasts.
To be sure, a breakthrough in the talks would lift the fog of uncertainty hanging over British companies, encouraging them to invest more and ultimately lift economic activity in itself.
Despite the breakdown in talks at the last minute on Monday the border issue with Ireland, foreign exchange derivative markets are betting on a breakthrough.
Three-month 'risk reversals' on sterling <GBP3MRR=>, which shows the relative pricing of puts and calls on the pound, have flipped to a bias of more sterling strength in the last week, though they remain below a 2017 high hit in early September.
Kallum Pickering, senior UK economist at Berenberg in London expects a transition deal to materialize by late 2018 an outcome that would boost economic growth to 1.8 percent.
It would also lead to a significant revaluation on sterling which according to SSGA's Binny is trading about 15 percent cheaper against the dollar on a valuation basis.
On a trade-weighted basis <=GBP>, sterling is trading at a six-month high and just one percent below a 2017 peak.
WALKING A FINE LINE
But even assuming a successful negotiation of the complex series of Brexit talks, sterling still has considerable headwinds against its two major rivals, namely the dollar and the euro.
Some market participants expect the U.S. may end up raising interest rates by as much as four times over the next 12 months after a landmark tax code overhaul over the weekend.
John Taylor, senior fixed income portfolio manager at Alliance Bernstein in London said the UK will have to raise rates by two times "at least to hang on to the coat tails of the Fed."
"The Bank of England can't afford to not tighten at all as that would weaken the currency a lot and if they hike more they may end up tipping the economy into recession well before Brexit kicks in," Taylor said who is underweight duration on UK debt.
Bond markets in the UK only expect one rate hike over the next twelve months. Against Europe, it is more of a differential growth story with growth in the currency bloc expected to pick up steam relative to the UK.
"Sterling movements have become kneejerk and pavlovian depending on the headline of the day and institutional investors are now focusing on the economic data," said Marc Ostwald, market strategist at ADM Investor Services.
(This version of the story has been refiled to fix date in dateline)
(Reporting by Saikat Chatterjee; Editing by Mike Dolan and Matthew Mpoke Bigg)