LONDON: Sterling dipped towards recent lows on Tuesday, two days before Scotland's independence vote, keeping the cost of hedging against sharp swings in the pound over the next week at its highest in four years.
Investors briefly focused on UK inflation data, after days of heated debate on the Scottish referendum, in which the pound is centre-stage. But consumer price rises slowed as forecast, barely diverting attention from the possible break-up of the United Kingdom.
Annual inflation for August was 1.5 percent, slightly down on July's 1.6 percent and well below the Bank of England's 2 percent target suggesting the central bank would be in no hurry to tighten policy.
Sterling was down 0.1 percent at $1.6210, having hit a 10-month low of $1.6052 last week. The euro was up 0.2 percent at 79.85 pence.
British government bonds tracked German debt higher. Ten-year gilt yields were 2 basis points lower on the day at 2.52 percent - just off a five-day low of 2.509 percent struck earlier - while the gilt's spread over 10-year Bunds was unchanged at just under 148 basis points.
"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 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.
Traders said there were few signs of panic amongst investors because most polls show the "No" vote marginally in front. Gambling company Betfair said it was already paying out winnings to customers who had staked money on a "No" vote.
But, with polls putting the vote too close to call, uncertainty over North Sea oil revenues, possible new trade barriers and, crucially, over which currency the Scots would use are likely to see investors avoid UK assets in the near term.
NO PANIC ATTACK
Investors have been unwinding expectations of a UK rate hike since the middle of last month. The BoE has said that unless wages and salaries star to rise, tighter monetary policy is unlikely.
Markets are pricing in a small chance of the first rate hike in the spring of 2015.
With uncertainty over the Scottish vote and 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 - bets on more declines - traders said.
Risk reversals, which gauge demand for options on a currency rising or falling, showed their biggest bias for sterling weakness against both the dollar and the euro in four years.
One-week sterling-dollar implied volatility jumped to its highest since 2010 last week and remained around those levels on Tuesday - implying a maximum swing in value over the course of a year at 17.5 percent.
Thursday's vote still carries substantial risks to that pricing, which implies a drop of 4-5 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 with whom they have spoken in the past week expect for sterling to drop to $1.50 if Scots vote "Yes".
"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.
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