FX: Sterling volatility here to stay as referendum countdown begins
The announcement of the referendum date of June 23 on UK membership of the European Union (EU) sent an already-weakening pound into a tailspin, which saw it testing multi-decade lows, but traders are divided on whether sterling has bottomed out as Brexit fears jump.
The Bank of England (BoE) monetary policy committee’s decision to keep rates at record lows contributed to a torrid week for sterling, but on this occasion it was the prospect of a British exit (Brexit) from the EU that was on trader’s minds as they frantically offloaded sterling.
Win Thin, BBH
GBP/USD fell to 1.4083 – its lowest rate since January 2009 – as part of a broad weakening that has seen the pound depreciate against almost all major currencies. This caps a period that has seen sterling fall by 10% against the euro since November, leaving EUR/GBP at its highest since December 2014.
This sterling sell-off comes despite the fact the euro is also being dragged down by Brexit fears, though to a lesser extent than sterling.
Traders are bracing for more of the same in coming weeks and months.
Andy Scott, economist at HiFX, says: “Risks now exist for GBP/USD to test towards 1.35, the low we saw after the financial crisis in 2009 and a historically important level.”
The 1.35 barrier is significant, he says, because it is the lowest GBP/USD has been since 1985 – and was the level at which sterling stopped falling after the financial crisis, when the pound collapsed by more than 30%.
Scott says: “Sterling is starting to look slightly undervalued and would expect it to find good support at 1.35, limiting further declines.”
Bill McNamara, technical analyst at Charles Stanley, says although sterling appears to be oversold relative to the euro, there appears to be scope for further weakness, adding: “A retreat to around €1.25 looks possible before too long.”
The BoE appears relaxed, though it would presumably be more comfortable with a more gradual decline.
It might privately welcome the decline in sterling since it will help lift import prices and put upwards pressure on the consumer price index, though it will be several months before the impact of weaker sterling is felt in the inflation figures – assuming it is sustained – and even longer for it to impact trade. Publicly, however, it is remaining neutral.
Société Générale research suggests the news that Boris Johnson, the popular London mayor, has aligned with the Brexit cause accounted for the severity of sterling’s sell-off.
“The Brexit camp has been split largely between the ‘vote leave’ and ‘grassroots out’ groups,” it says. “Thus, the possibility of a popular unifying figurehead for the Brexit campaign would be a huge game-changer.”
Others point out it is not only sterling weakness but dollar strength that has contributed to extreme moves in that pair specifically.
That particular rate will continue to be determined as much by US data as by UK political concerns, says Caxton FX analyst Nicholas Laser-Ebisch, though sterling strength more broadly “will likely depend on the information that is presented in the next four months as to whether or not the UK will exit the EU”.
As such, while recently the ‘leave’ campaign has dominated the headlines and sterling has therefore suffered, any perceived victories ahead of the vote by the ‘remain’ campaign – favourable polls or reputable businessmen coming out in favour of staying in Europe, for example – might lead to similar sterling gains.
HiFX’s Scott draws parallels with sterling volatility in the months leading up to Scotland’s independence referendum, adding: “As we approached the vote, the polls began to have a greater impact on sterling with it falling sharply due to a narrowing of the lead of those voting to stay part of the UK.”
Laser-Ebisch at Caxton cautions sterling moves might feel quite random as sentiment is pulled in different directions by various commentators on Brexit.
“We will likely see exchange-rate swings of up to 5% in the next four months,” he says, having already witnessed moves of 6% and 8% in GBP/USD and GBP/EUR, respectively, this year.
What might occasionally get an airing is the relatively strong performance of the UK economy.
Scott says: “The fact that the UK has grown at a faster pace than many other major economies, with unemployment at its lowest for a decade, provides confidence in the overall strength of the economy.”
Others assessing British fundamentals draw different conclusions.
Credit Suisse says: “The speculative market is not especially short GBP, suggesting that the flows reflect real hedging of positions linked to the UK’s massive 600% of GDP external balance sheet.”
However, Laser-Ebisch doubts many traders are thinking about such things.
“External influences such as inflation, Bank of England meetings, and other economic indicators will likely not carry as much weight between now and June when it comes to the value of the pound,” he says.
With so much uncertainty, reflecting the lack of consensus about how Britain will vote and what the ‘leave’ outcome will mean in practice, traders are naturally likely to hedge their sterling positions.
“In a typical year, the average range between the high and the low in sterling versus the US dollar equates to about 10%,” says Scott. “We’ve already seen 6% in just two months and the options market is indicating heightened levels of volatility, with demand for protecting against sterling weakness near a record high.
BBH’s Thin adds: “Implied volatility is rising, which suggest puts being bought rather the calls being sold.”
Three-month implied volatility was near 11.5% this week, he notes, up from 8.7% at the end of last year and 8.9% at the end of January.
“The pace of sterling’s decline and the market’s anticipation of further declines, as reflected in the risk-reversal, do not show sterling at some kind of extreme, even though the market is stretched,” says Thin.
All this drama will prove a mere sideshow compared with the volatility that is likely to accompany a vote to leave in June.
“We’re continuing to highlight the risks to clients of this referendum, which, if results in the UK voting are to leave the EU, could see a further, sharp depreciation in sterling of 10% to 15%,” says Scott.
“This recent movement once again highlights the need for corporates to undertake some form of hedging, to avoid being caught out by significant swings that can eat away at profit margins or even lead to losses.”