Sentiment has shifted in GBP s favour but can it last

Last week’s High Court decision regarding a parliamentary vote and the triggering of Article 50 may highlight the deep political divisions within the UK, but traders want to know whether it is a game changer for the pound right now. Could the sustained sell off in GBP be coming to an end?

While the political ramifications of the Court decision essentially mean that a slower, softer Brexit may be more likely, it is worth looking at the microstructure of the FX market to see what is going on and if there has been a significant shift in sentiment towards the pound since Thursday.

Below we will assess how the retail, speculative and options market have reacted since the ruling, and whether or not this gives us an indication of where the pound could go next. We will be looking at GBP/USD as this is the most liquid GBP pair.

1, Options market

We looked at GBP/USD’s risk reversal, which can be a useful way to gauge how market participants are betting on a currency move. Risk reversals in the FX market measures the difference in volatility between call and put options. There has been a positive rise in the risk reversal for GBPUSD across time frames in recent days, this means that the volatility of calls has risen at a faster pace than the volatility of puts, which suggests that the market is betting on a currency rise, or in the case of the pound, a recovery.

GBPUSD risk reversals are still in negative territory, however they have recovered across the curve since last Thursday, after reaching a low in mid-October. The chart below shows the 6-month risk reversal for GBPUSD. We chose this time frame, as pre Thursday’s ruling the UK could have triggered Article 50 within 6-months. The fact that the risk reversal at this time frame is recovering suggests that the market could be shifting towards a less bearish stance towards the pound on the back of a delay to the UK leaving the EU, and potentially a softer Brexit than what the market thought last month.

Figure 1: GBPUSD risk reversal 6-months contract

Source: City Index and Bloomberg

2, Speculative market

CFTC positioning data measures the positioning of the non-commercial, speculative, sector of the market. These are usually large hedge funds and other traders who have built record short positions in the pound since the end of 2015. However, short positions were scaled back further last week, after reaching a record low at the start of October. We think that this data will continue to show a scaling back of long positions this week, regardless of the US election result, as it fully takes into account the Article 50 ruling. Although the market is still net short of GBP, any signs that it is cutting back on its short GBP positions could be good news for the long-term trend of the GBP.

Figure 2: CFTC positioning data is now less bearish on cable than it was a few weeks’ ago.

Source: City Index and Bloomberg

3, Retail market

At the time of writing our clients who trade GBPUSD are nearly 70% long the pound, even though cable has fallen on Monday on the back of the latest polls in the US election putting Hillary Clinton in the lead. Retail clients may be favouring the pound for two reasons: 1, they may be buying the pound on dips versus the USD, 2, they may take the view that the worst of the selling pressure is over for the pound now that the brakes may have been put on triggering Article 50. It is hard to gauge long-term sentiment from retail traders, who tend to hold positions for shorter time periods, but it does suggest that the retail community is confident on the pound even with US election risk looming.

Wrap-up

Overall, while we wouldn’t say that this is a sign that the market is diving into GBP longs, it is a sign that the market is now less bearish on the GBP compared to a few weeks’ back. When the options market and speculative segment of the FX market start to shift their views on a currency it is worth noting, as it can be a sign of a more prolonged period of recovery for GBP. While we think the US election result has the propensity to disrupt a GBP/USD rally in the short term, we could still see this pair trade above 1.25 in the coming days and weeks.