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GBP appears to be one of the most vulnerable currencies to pandemic COVID-19, not only because the damage to public finances is larger than most other countries (a 2020 fiscal deficit of 16% of GDP), but also because the UK has the largest G10 external financing requirement. This reliance on inflows renders GBP more vulnerable to the depressing effect on yields from the BoE’s QE (now 14% of GDP this week); not only that, it will be interesting to see how a current account deficit currency such as GBP copes with negative rates if the BoE does indeed decide to push the policy envelope in that direction later this year.
Sterling is also liable to become ever-more idiosyncratic as the UK nears the business end of the entire Brexit process and the market tries to benchmark the potential outcomes and eventually shifts from valuing GBP on a probability-weighted basis to pricing a central scenario and then the outcome itself. Assessing what GBP would do in each of the three main scenarios - no trade deal; a bare bones deal for a limited portion of the goods sector; and a full-blown FTA that would eventually encompass the services sector – requires an assessment of the current risk premium in GBP.
We quite often use the REER as a valuation proxy but suspect this overstates the risk premium (GBP's REER is 12% below it 20Y average). A better indication is likely to be the undervaluation in GBP based on the interest rate relationship that prevailed up till the referendum. This approach indicates a 5% risk premium. As such it tends to underscore our assessment that there is more downside for GBP on a no-deal outcome (cable to test the 1.15 lows again) than (upside on a trade deal (low 1.30s), certainly a bare bones deal in which the service sector would lose single market access and the trade in goods would be disrupted by regulatory changes and potentially also tariffs.
On trading perspective, activated longs in EURGBP from 0.895. Marked at 1.13%.
At spot reference: 0.9037 levels, contemplating above factors, it is advisable to trade 2m boundary option strategy using upper strikes at 0.93 and lower strikes at 0.8750 levels, the strategy is likely to fetch leveraged yields as long as the underlying spot FX remains between these two strikes on the expiration.
Alternatively, long hedges via EURGBP CME futures of June deliveries were activated with an objective of arresting foreseeable upside risks, they have fetched us desirable results so far. We now wish to uphold the same long hedges by rolling over to July expiries.
Unwind shorts in GBPSEK at 11.678 with a stop at 11.950. Marked at +0.26%.
Finally, sell GBPCHF at 1.176 with a stop loss at 1.205. Courtesy: JPM