Brexit negotiations have once again come to a standstill after Britain’s international trade secretary, Liam Fox – a prominent ‘Brexiteer’ said that the likelihood that the United Kingdom (UK) leaves the European Union (EU) with a ‘no deal’ is as high as 60%. This followed comments from the governor of the Bank of England (BOE), Mark Carney, who called this risk as “uncomfortably high and highly undesirable”.
If no deal is reached, Britain would withdraw from the EU without any of the trade, customs and regulatory measures. As Britain moves closer to the March 2019 deadline for its official exit from the EU, growing concern about a messy divorce has driven sterling down even after the BOE raised interest rates last week.
The cable currency tumbled to $1.2920 on Monday which is the lowest level in 11 months.
What to expect?
When trying to understand currency movements, an important measure to look at is the *25 Delta Risk Reversal metric which shows the difference in volatility, and therefore price, between puts and calls on the market. Positive risk reversal means that the volatility of calls is greater than the volatility of similar puts. Negative risk reversal means that the volatility of calls is lower than the volatility of similar puts.
When we look at the GBP/USD we can see that the risk reversal is negative for all the periods in question (see chart below). This therefore means that more market participants are betting on the drop of the GBP rather than a rise.
Another example can be taken if we look at the EUR/GBP. In this case, risk reversal is positive for all periods in question and thus market participants are betting on a rise in the base currency (EUR) against the GBP.
Over the months we have had various halts in the UK/EU negotiations and although there is always hope that the two sides move closer to a compromise, various market analysts are arguing that this may only happen if there is sufficient market pressure which will in turn increase currency volatility.
Credit Agricole analysts are forecasting that the GBP/USD drops to 1.20 in the event of ‘no deal’ by the time the UK is officially out on the 29th of March 2019. Alternatively, the cable should move to 1.39 or higher if the ‘no deal’ Brexit event is avoided. In EUR/GBP terms, we are looking at a 0.95 level which would be consistent if the UK leaves the EU without a deal.
As we have seen from the table below, risk reversals for GBP are increasing however they are still not close to the 2016 highs following the actual referendum. This might indicate that a ‘no deal’ might have a marginal effect on currency or, more likely, that the market has not yet priced in a ‘no deal’ outcome which creates a very interesting investment opportunity.
The months to come will also be crucial to understand were the currency is heading because changing the official stance from soft to hard Brexit will surely push the GBP even lower.
*25 Delta risk reversal
25-delta risk reversals show the difference in volatility, and therefore price, between puts and calls on the most liquid out-of-the-money (OTM) options quoted on the OTC market. Positive values indicate calls being more expensive than puts (upside protection on the underlying forex spot is relatively more expensive), while negative values indicate puts are more expensive than calls (downside protection is relatively more expensive).In other words, a positive risk reversal means the volatility of calls is greater than the volatility of similar puts, which implies more market participants are betting on a rise in the currency than on a drop, and vice versa if the risk reversal is negative. Thus, risk reversals can be used to gauge positions in the FX market and convey information to make trading decisions.
Risk reversal data source SaxoBank.
Past performance is not a guide to future results. This information is being provided solely for information purposes and should not be deemed or construed as investment advice, advice concerning particular investments, advice concerning investment decisions, tax or legal advice. Similarly, any views or opinions expressed are not intended and should not be construed as investment, tax and/or legal recommendations or advice. No person should act upon any opinion and/or information in this document without first obtaining professional advice.