By Saikat Chatterjee
LONDON (Reuters) – Currency traders who were wary of positioning outright for a hard Brexit outcome may finally be throwing in the towel: heavy selling has hit sterling this month and metrics such as derivatives and positioning suggest no respite ahead.
The question for the markets and public alike is just how far sterling could now weaken.
Just a cursory reading of historical chart troughs shows $1.20 within easy reach.
But major UK banks, such as HSBC, are already talking of the possibility it breaches post-Brexit referendum lows of $1.1491. And then sights get trained on the historic all-time low of $1.0545 from March 1985, just before G7 powers acted to rein in the superdollar of the Reagan era in the so-called “Plaza Accord”.
Chart levels aside, is the pound headed for parity against both the dollar and the euro?
The broad view that Britain would manage to agree some kind of transition trading agreement before leaving the European Union had until now kept investors more or less on the sidelines on sterling, out of concern that a last-minute compromise would send the currency rocketing higher.
But even though a no-deal Brexit is still seen as unlikely, market players are actively positioning for it by dumping the pound. Since the 2016 EU referendum, the currency has been the clearest way for markets to express Brexit risk.
What has changed?
Arch-Brexiteer Boris Johnson looks a shoo-in to take over as prime minister next week with a pledge to take the country out of the EU on Oct. 31 come what may.
Then a growing swathe of dismal economic data has highlighted the Brexit fallout; it seems even to have persuaded the Bank of England to turn more dovish
All that has sent the pound reeling 6% since early-May. It is wallowing at a two-year low below $1.24, having traded near $1.34 as recently as April. But its losses are far from over, options and futures imply.
(For a graphic on ‘One direction for sterling’, click https://tmsnrt.rs/2NZstIC)
$1.20 IN MY EYES
Options data indicates little support for the pound until it hits $1.20, a level where large “strikes” amounting to around $1 billion, have amassed. These strikes — essentially the price at which the option can be exercised — expire over the next two weeks.
Until recently, sterling was supported by option holdings around $1.25; banks selling such structures on to clients bought the currency around that level, preventing sharper falls. But once that level gave way in early July, banks had to cut their positions. That would have accelerated the drop to $1.24.
The risk is markets remain unprepared for bigger falls – there are few large options until $1.20 and very few beyond that.
(For a graphic on ‘GBP FX options’, click https://tmsnrt.rs/2NV7erg)
There are still some who remain wary of buying and selling sterling because of its sensitivity to Brexit headlines. But even they are certain the currency is set for a volatile ride from here.
A look at the term structure of implied sterling/dollar volatility shows that three and six-month gauges of expected swings in the pound have jumped far more than one-year segments — clearly investors are taking no chances around the Oct. 31 deadline.
As demand for these options has surged, market-making banks have sharply hiked the cost of three-month-expiry implied volatility options, even though the contract does not yet roll to Oct. 31.
Three-month implied volatility, bid at five-year lows around 6 vols in April, has spiked almost 2 vols in the past 10 days to around 8.1 vol — a 25% price increase.
“Pound volatility is picking up but is very cheap compared to the highs of last December and should keep moving higher,” Nomura strategists told clients.
(For a graphic on ‘Option structures’, click https://tmsnrt.rs/32yCiQP)
(For a graphic on ‘Implied volatility’, click https://tmsnrt.rs/2NXNhjJ)
NOT A VERYBIGSHORT
Often an asset’s price may be supported if investors are already “short” — essentially a bet on prices falling in the near future. Hedge funds indeed hold a substantial short position in sterling futures but the catch is that their cumulative short position is still far from an extreme amount. extreme. Net short in the market is still some way off from the record levels.
As of July 16, sterling short positions amounted to $5.7 billion, having risen for four weeks straight. But last September, the short was as big as $6.5 billion and it hit a record $8.4 billion in March 2017.
(For a graphic on ‘GBP positions’, click https://tmsnrt.rs/2k0FOSS)
Nor is there much support in store for sterling from a technical perspective. Chartists flag minor support around $1.233 level but the next level of support kicks in only around $1.15 — levels touched in the aftermath of the 2016 Brexit referendum.
Another technical indicator known as the RSI that measures whether currencies are oversold or overbought, also implies the recent drop in the pound is not that extreme. Greater extremes were seen during September 2018 and October 2016.
Against the euro, while the pound is approaching the psychological level of 90 pence, there is little support given how rarely sterling has traded below those levels in the past.
BNY Mellon strategists note the pound has only traded less than 3 percent of the time below the 90 pence per euro level since the single currency came into existence in January 1999.
“These are uncharted levels for the pound and there is more pain likely in store,” said Neil Mellor, a senior FX strategist at BNY Mellon in London.
(For a graphic on ‘GBP technicals’, click https://tmsnrt.rs/2NZkGKE)
(Reporting by Saikat Chatterjee; Additional reporting by Richard Pace; Editing by Sujata Rao and Frances Kerry)