By Ritvik Carvalho
LONDON (Reuters) -Sterling hit its lowest since end-2020 against the dollar on Wednesday, erasing all its gains for the year as concern about soaring natural gas prices and almost a week of petrol shortages in Britain outweighed a recovery in global equity markets.
The pound generally trades in line with global risk sentiment and was hit by a global equity selloff on Tuesday when investors braced for future rate hikes from global central banks, most notably the U.S. Federal Reserve.
Although stocks staged a recovery on Wednesday, sterling extended its Tuesday losses and fell another 0.7%, to its lowest since Dec. 28 against the dollar at $1.3440.
The two consecutive daily drops - on a two-day basis, the worst since September 2020 - have left the pound flat against the dollar for the year.
Sterling was at one point the best performing G10 currency in 2021, boosted by high expectations for an economic rebound in Britain on the back of the country's vaccination programme.
That narrative has crumbled under the weight of a post-Brexit shortage of lorry drivers that has sown chaos through British supply chains in everything from food to fuel, raising the spectre of disruptions and price rises in the run-up to Christmas.
Drivers have been panic-buying fuel for almost a week, leaving pumps dry across major cities, after oil companies warned they did not have enough truck drivers to move petrol and diesel from refineries to filling stations.
"The pound is still suffering from the perception of domestic shortages, higher inflation and the prospect of a winter of discontent all weighing on previously up-beat expectations for the currency," said Neil Jones, head of FX sales, financial institutions at Mizuho Bank.
A key gauge of the financial market's expectations for inflation in Britain over the coming years, watched closely by the Bank of England, rose on Tuesday to its highest level in at least eight years, as gilt yields surged.
The supply crunch has also pushed up a market measure of inflation expectations to its highest level in at least eight years, amid a broader surge in government bond yields.
The five-year, five-year forward inflation-linked swap - a proxy for inflation expectations over the next five years - rose to 3.905%, the highest since daily records published by Refinitiv began in 2013, and up from 3.878% on Monday.
The move reflected a growing conviction among investors that rising inflation in Britain will not prove to be as transitory as the Bank of England hopes, with recent supply chain problems escalating into a full-blown crisis over the past week.
"Investors fret about the looming stagflation risks ahead that could scupper the UK economic recovery and force the MPC (Monetary Policy Committee) to reconsider its plans for policy normalisation," said Valentin Marinov, head of G10 FX research at Credit Agricole (PA:CAGR).
A less proactive Bank of England could result in even more negative UK rates and gilt yields, Marinov said, adding that a short position on the pound is the "best stagflation hedge" that the G10 market can offer at the moment.
Bank of England governor Andrew Bailey is scheduled to speak at a forum in Sintra, Portugal later on Wednesday.
COMPETING EXPLANATIONS
Analysts have offered competing explanations for the pound's move, ranging from the surge in natural gas prices, month-end portfolio rebalancing, leveraged funds' long positions and the broader fall in risk sentiment.
"Gas prices are moving in an extreme manner, so why not in FX too? The concern for macro investors is if GBP becomes a market that will become truly unpredictable," Jordan Rochester and George Buckley at Nomura said in a note.
"Perhaps the UK suffers from continuous headline shock risks, as it used to in the Brexit politically driven GBP era (2016-2019), which was a time when many macro investors looked elsewhere for more thematic-driven trades. It’s something we don’t expect to happen for a considerable amount of time but a risk on days like this we can’t ignore."
Others, such as BoFA Global Research's Kamal Sharma point to month-end rebalancing and BMO Capital Markets' Stephen Gallo also cited positioning.
"We pin the sentiment shift in the GBP during the past 24 hours on the deterioration in risk sentiment and a risk-off cleanse in GBP longs held by leveraged funds," he said.