Options market shows corporates unprepared for sterling slide
The speculative trading community may have been prepared for the latest sharp drop in the pound, but price action in the options market suggests that corporates are unready for heavy sterling losses.
That should ensure that the downtrend in the pound still has some way to go as that market segment covers its exposure to the sliding pound.
Speculative positioning indicators, such as the weekly IMM data produced by the CME, showed that leveraged accounts were already short of sterling ahead of last week’s Inflation Report from the Bank of England.
Last week’s revelation that the Bank had effectively suspended inflation targeting subsequently sent the pound tumbling.
That move was extended on Wednesday after the release of the minutes of the Bank of England’s February Monetary Policy Committee meeting, which showed that Mervyn King, Bank governor, and Paul Fisher had joined arch dove David Miles in looking for a £25 billion increase in the UK’s asset purchase scheme to £400 billion.
Although outnumbered on the committee, which left the size of the scheme at £375 billion, the fact that two Bank insiders were now looking to counter balance the aggressive quantitative easing and weak currency stance in Japan and the US pushed the pound sharply lower, with GBPUSD crashing down through the 2012 low of $1.5230.
The news from the Bank of England simply added to the negative sentiment surrounding sterling, which was already under pressure amid weak UK growth, rumours of a sovereign downgrade and a scheduled referendum on Britain’s EU membership if the Conservative Party wins a majority at the next general election.
Admittedly, that last factor is a big “if”, and it might be better to focus on the prospects of a disintegration of the UK’s ruling coalition government as the Conservative and Liberal Democrat parties squabble over who is to blame for Britain’s economic woes.
Nevertheless, it all adds up to a toxic mix for the pound, and one which could see momentum funds drive GBPUSD down through $1.50 towards technical support in the $1.4800/1.4850 area.
|GBPUSD risk reversal skews far from extreme|
The options market reveals that corporates are not yet fully prepared for the move, however.
The sharp drop in GBPUSD and jump in realised volatility has seen the price of sterling implied option prices increase. One-month GBPUSD traded option prices have jumped to 8.3% this week from 7.9% at the end of last week.
However, Chris Turner, head of FX strategy at ING Financial Markets, says the one-year risk reversal skew in sterling – the price of a one-year put versus a similar call – implies that the corporate market is only now starting to prepare for losses in the pound and insure against a further fall in sterling.
Typically, the one-year area of the options curve is more determined by corporate than speculative accounts. Indeed, the move towards yen puts in the one-year area of the curve proved a strong signal that Japanese corporate sentiment had turned on the currency in December.
“With the one-year GBPUSD risk reversal merely showing a 1.6% skew for sterling puts, it suggests that corporates are nowhere near as prepared for GBPUSD weakness as they were when it last traded down to these levels in 2012 and late 2011,” says Turner.
As the chart above shows, the skew for sterling puts in the GBPUSD one-year risk reversals was trading above 2.5% when the pound plunged in 2012 and close to 3% in late 2011.
Turner believes a better risk environment and expected dollar weakness in 2013 may have seen sterling bearishness among corporate investors relatively contained prior to its recent slide.
“The corporate community is probably not on this GBPUSD decline yet, and could provide a significant catalyst for much lower levels in sterling,” he says.
“While GBPUSD has fallen a long way already, we see value in a variety of option structures to catch the move down to $1.48.”
The slide in the pound may soon find a new impetus.