Sterling tensions could ease till December

Summary

An extended Brexit transition period is unlikely, but sterling conditions could be relatively calm before a parliamentary vote.

Sterling under less pressure

We continue to view sterling pricing as optimistic. Note that it remains on the high side of the region that spans last Thursday night’s $1.2722 low and this morning’s $1.2879 high. Traded against the dollar, the pound drifted higher towards the end of last week and has not seen a serious upset since. This is largely due to a mixture of dollar consolidation, short-covering and the Brexit deal impasse itself—fresh developments have been limited.

Options reality check

For market participants, hedging and speculative option indications suggest positions remain costly to enter and hold. Nevertheless, demand for protection is robust. Sterling/dollar risk reversals from the shortest-term to those covering six months or more ahead are priced at the lowest since September 2016. This points to the most bearish expectations for the pound since the referendum. Friday brought the first lower close in in six sessions for key pound options across most maturities. But implied volatility in these trades, or how much sterling is expected to swing, is still close to the most elevated levels since mid-2016. In short, whilst it’s guesswork to state exactly when the pound will crater further, the bias obviously points to the downside.

Sterling weaker vs. euro

In the absence of any (highly unlikely) improvement in Brexit deal prospects and whilst UK government stability remains equally difficult to predict, the lack of a further slide by the pound towards its August low of $1.266 over the last week or so, will continue to look incongruous. Superimposing the chart of cable against that of euro/sterling (see Figure 1.) reveals a deeper discount of the pound since GBP/USD touched a new two week low on 15^th November. EUR/GBP pricing, which removes most reckoning about dollar sentiment, suggests GBP/USD could decline in the near term, to reflect a further, truer, deterioration in sentiment since late last week.

Monday reckoning

Monday did bring the largest downswing in the pound traded against the dollar since Thursday evening’s drama. Whilst there were no critical occurrences, the market was reacting to Prime Minister Theresa May stating that an extension of the Brexit transition deal was unlikely. The PM also noted it was important for the UK to be out of the implementation period before a 2022 general election. These were not surprising utterances. However, they underlined another element on which Theresa May has not changed her mind. As such, a potential confidence procedure on the Prime Minister is what traders should watch most intently. Our best assumptions are as follows.

1. Some sort of deadline for gathering the 48 MPs’ letters required to bring a confidence motion will occur at the end of today.
2. The tally was reportedly six letters short on Monday morning.
3. Failure to secure 48 letters on Monday reduces the chance of a vote before Sunday’s emergency EU summit.
4. In the event of a vote, 158 would be required to carry the motion.
5. If not carried, party rules dictate that no further confidence vote in the leader can be held for a year.

All of this continues to point to the parliamentary vote as the likeliest occasion when the agreement may hit a brick wall. Therefore, further incursions to the upside of the sterling range and even beyond are difficult to rule out. Optimistic scenarios could certainly gain traction in the market between now and the probable early December scheduling of a House of Commons vote. During that time, elevated option pricing could weaken demand, and hence implied volatility could also ease. Depending on the direction of the Commons vote, such easier sterling conditions would probably be temporary.