Sterling has become The Big Short.
Net short positions on the pound have risen to the highest level since the summer of 2013 as investors bet on a further steep fall in sterling amid worries over whether Britain will stay in the EU.
Unlike the big short on subprime loans, which the blockbuster film and book by Michael Lewis is based on, the Brexit vote is unlikely to cause a savage financial crisis. But it could have damaging consequences for the UK economy.
Ah, some might say, isn’t a weaker currency good news for the economy and UK exporters, as goods priced in sterling become cheaper and more competitive overseas?
It should also be noted that the pound rallied the last time net short positions, as measured by the US Commodity Futures Trading Commission, were this high in July 2013.
Yet, pessimism surrounding sterling, which has dropped about 8 per cent on a trade-weighted basis since the middle of November, is like the canary in the coal mine. It is signalling trouble ahead.
As Mark Carney, the governor of the Bank of England, said in January, concerns about a UK exit from the EU could test “the kindness of strangers” the country relies on to fund its hefty current account deficit with the rest of the world.
Mr Carney makes the point that the vote on the membership of the EU, which is likely to come as early as June, highlights the dangers of having a large current account deficit of 3.7 per cent of gross domestic product.
The governor is clearly worried that overseas investors might start to fret. They hold £427bn in UK government bonds, a quarter of the market.
If a sizeable number of these foreign investors decide to sell, it could have serious consequences for the UK and its ability to fund its deficit.
This would come at an awkward time, when liquidity in gilts has fallen sharply. Banks are no longer prepared to hold large amounts of government bonds on their books and provide the market-making function that ensures steady volumes.
Both Mr Carney and the UK Debt Management Office, which is responsible for selling gilts, have become increasingly concerned about liquidity, which is, in essence, the ability to buy or sell a security quickly.
Indeed, Mr Carney reportedly lost his temper when told by a Bank of England official that there was not a liquidity problem in gilts. The official was told to look more closely at the market and report back again.
For its part, the DMO commissioned Morgan Stanley, the US investment bank, to carry out an internal report on liquidity and volumes in gilts. Morgan Stanley found that liquidity had dropped sharply since 2012, which has resulted in declining demand at gilts auctions.
This fall in liquidity could cause the market to suddenly gap higher or lower, resulting in heavy losses for some investors.
The market has not forgotten the sharp swings in German Bunds, which was partly caused by a lack of liquidity, in the spring of last year. Yields jumped from 7 basis points to 98bps in a matter of weeks.
John Roe, head of multi-asset funds at Legal & General Investment Management, says: “Liquidity is partly what attracts investors to markets such as gilts. If you are no longer sure you can liquidate your positions as easily, then that could have a very damaging effect.”
John Wraith, UK strategist at UBS, the Swiss bank, adds: “The market is worried about Brexit and the uncertainty it would surely trigger. This could spark another big drop in sterling. The concern is the speed of the fall. The pound would have to drop very sharply from here to cause real problems for the economy, but it is a real risk.”
At this stage, a further big plunge in the pound looks unlikely, since the odds favour the UK voting to stay in the EU. Betting agencies, considered more reliable than opinion polls, say the chance of a vote to leave is only 30 per cent. Concerns about Brexit are probably priced into the market to a large degree, too.
But, with David Cameron, the UK prime minister, expected to announce a date for a referendum soon, possibly at the end of this week at the European summit in Brussels, the stakes are about to rise.
The big short in sterling is a warning sign of potential turbulence in UK markets that investors would be foolish to ignore.
David Oakley is the FT’s corporate affairs correspondent
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