LONDON: Sterling fell towards recent lows on Tuesday, keeping the cost of hedging against sharp swings over the next week at its highest in four years, as Scotland's vote on independence approaches.
Investors briefly focussed on UK inflation data, after days of heated debate on the Scottish referendum debate, where the pound is centre-stage. But inflation fell in line with forecasts and did little to divert attention from the possible break up of the United Kingdom.
Annual consumer inflation for August was at 1.5 percent, slightly lower than 1.6 percent seen in July. That was well below the Bank of England's (BoE) target of 2 percent, suggesting the central bank would be in no hurry to tighten policy.
Sterling was down 0.3 percent at $1.6175, having fallen to a 10-month low of $1.6052 last week. The euro was up 0.4 percent at 80.02 pence.
"In the bigger picture, what we had previously was UK interest rate hike expectations were driving the pound higher. But with inflation pretty subdued, monetary policy is likely to remain unchanged," said Nawaz Ali, market analyst at Western Union.
"At the same time, what is hurting sterling is all the uncertainty over Scotland and what could happen to the remaining UK, in case of a `Yes' vote."
Sterling has lost 2.5 percent against the dollar so far this month, amid concern a Scottish vote for independence would undermine investment and growth and prompt the BoE to push back an expected rise in interest rates.
A split is also likely to see the remaining UK left with more debt, which could lead to a possible credit downgrade by rating agencies and outflows from Britain. Uncertainty over North Sea oil revenues, possible trade barriers between the two countries and, crucially, the issue of which currency the Scots would use were also weighing on sentiment.
UNCERTAINTY
Investors have been unwinding expectations of a UK rate hike since the middle of last month. Data showed wage inflation was rather subdued and the BoE said that unless wages and salaries started to rise, tighter monetary policy was unlikely.
Markets are pricing in a small chance of the first rate hike in the spring of 2015.
Given all the uncertainty over the Scottish vote and question marks over the durability of the UK economy, hedge funds continued to seek protection against near-term swings in sterling. Many were buying options with downward strikes -betting on more declines, traders said.
Risk reversals, a gauge of demand for options on a currency rising or falling, were showing an increasing bias for sterling weakness against both the dollar and the euro.
One-week sterling-dollar implied volatility jumped to its highest since 2010 last week and remained around the same levels on Tuesday - implying the maximum swing in value over the course of a year at 16 percent.
Thursday's vote in Scotland still carries substantial risks for that pricing, which implies a drop of 3-5 U.S. cents in sterling from current levels. A number of analysts have said sterling would fall more than that in the event of a "Yes" vote.
RBC Capital said investors they have spoken in the past week are looking for sterling to drop $1.50 in case Scotland voted to become independent.
"Most agreed it would hit there and gradually recover. A minority claimed that the cable will continue to drift lower from $1.50. This is because some of the damage will switch BoE bias to outright dovish for a long while," RBC said in a note.
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