Hedge funds have significantly reduced their British Pound (GBP) holdings due to concerns over the UK's fiscal situation and a waning demand for its 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 the norm in the past two weeks, marking the most substantial flows since November.
Historical patterns suggest that, following such intense selling pressure, the GBP against the US Dollar (GBP/USD) often experiences a minor recovery. Data from the past five years indicates an average rebound of 0.6% in the nine days following similar selling events by hedge funds.
However, the trend does not seem to hold for long, as typically, the GBP/USD starts declining again, with an average drop of 1.4% from the ninth to the fifteenth day after the selling peak.
UBS analysts also expressed a bearish outlook on the GBP, citing structural issues within the UK's 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 the 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, potentially offering some respite to UK rates.
However, such a rate cut might not bolster the GBP, as it would reduce the currency's interest rate differential advantage. From a valuation standpoint, UBS's regression-based model indicates that the Euro against the GBP (EURGBP) is still relatively cheap, with a z-score of 2.5.
UBS suggests that selling GBP in favor of the Euro could be a strategic move to sidestep the possible short-term rebound of the GBP/USD.
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