One year since former Prime Minister Liz Truss’s spending plans drove the pound to a record low, markets are again turning against the British currency.

For months, investors have been piling in to take advantage of soaring UK interest rates. Yet Thursday’s surprise decision by the Bank of England to stay on hold has refocused bears on the nation’s fundamentals, which remain tepid even as the impact of last year’s crisis fades. Many are now betting that sterling will enter a sustained downward trajectory against the dollar.

“A year ago it was fiscal credibility that markets were questioning,” said Adam Cole chief currency strategist at RBC Capital Markets. “This time it is monetary policy credibility.”

Widening cracks in the UK’s economic data and fears that higher rates will exacerbate a potential recession prompted the BOE to call time on its rate hiking cycle. But traders warn policy makers could be underestimating a host of factors that still threaten to push consumer prices higher.

After topping returns among its Group-of-10 peers in the past year, September saw the pound place last and Thursday’s decision tipped sterling to a six-month low versus the greenback. Asset managers trimmed long positions, flipping to bet against the currency.

RBC and HSBC Holdings Plc. are bracing for more weakness. Bank of America Corp and BNP Paribas SA warn that a sharper slide is in the cards if positions are unwound further.

“The really negative moves will come for sterling when, not if, we start to see much more pronounced weakness in the data,” RBC’s Cole said.

The UK will continue moving into recessionary territory and this will push the pound-dollar pair down around 5% to 1.17 by year-end and 1.11 by the second half of next year, he said.

Bullish on the pound since November last year, Dominic Bunning at HSBC is confident the rally now has no more room to run. Rates at their peak means the currency is poised to slump almost 4% to around 1.18 against the dollar in the next nine months, the head of HSBC’s European currency research said.

What Bloomberg strategists say...

It’s hard to assign a high probability to a strong rebound for sterling, even though it has a unique way of defying options gauges and technical analysis. Given the macro backdrop, cable looks on its way to test $1.2075, a key Fibonacci retracement, which would be a 8% drop from its July highs. Further weakness would need money markets to pencil in deep rate cuts by the BOE next year.

- Vassilis Karamanis, FX and rates strategist at Bloomberg

Despite asset managers turning against the pound, hedge funds still hold bullish positions in the UK currency near their highest on record. The pound is currently their longest Group-of-10 currency trade, according to Bank of America flows data, leaving it vulnerable if dollar strength in the near-term triggers further unwinding.

Following the Swings

Trend-following hedge funds — known as CTAs — could exacerbate the moves if there’s a rush for the exits, BNP Paribas said.

CTAs typically track swings in markets, switching strategy to follow the overall direction. As investors absorb the end of the BOE’s hiking cycle and the pound comes under further pressure, more of these funds will switch to betting on weakness, BNP said.

“CTA positioning is extremely long the pound,” said Parisha Saimbi, a currency strategist at BNP Paribas. “Given the bearish catalyst from the BOE having paused, and with the data likely to decelerate, positioning reduction by these accounts could exacerbate downside moves in the pound.”

The pound’s fortunes against the dollar may look dim, but sterling could prove resilient compared with the euro as economic growth and inflation on the continent for once more of a cause for alarm than in the UK.

“If you have less interest rate hikes in the system, then you’re also reducing recessionary risks” in the UK, said Jane Foley, head of currency strategy at Rabobank. “With the growth clouds darkening over Germany and perhaps lifting slightly over the UK, the outlook for sterling may have improved a touch.”

Markets have largely put the UK into a “secular stagflation camp” ever since Truss’s unvetted mini-budget last year, but Europe is now heading into the same camp, said Geoff Yu, senior market strategist for Europe, the Middle East and Africa at BNY Mellon, who sees this prompting a re-allocation of assets.

“Downside risk to the pound and UK assets in general will not be as big as for Eurozone equivalents,” he said.

Still, overall investor allocations still gravitate toward the US, Yu said, and the pound’s path below $1.20 in the near future is a near-certainty.

“It’s a comparison of who’s going to lose the race at the bottom.”