FxWirePro: Is Theresa May’s departure a boon or a boom? Sterling still looks vulnerable in OTC markets as Brexit dust remains unsettled

PM Theresa May stepped down as party leader on Friday. She will remain in office until her successor will be appointed (probably at the end of July) but her time is over and the first round of power struggle has started, with possible candidates positioning themselves.

The front-running Boris Johnson who received support from the US a couple of days ago is already sharpening his language and sends tough signals to the EU. The former foreign secretary would not pay the exit bill and withhold the EUR 44 bn exit payment which was agreed on in the withdrawal agreement.

Moreover, he plans to scrap the Irish backstop and to exit the EU on Oct 31st, be it without a deal. Basically, this means that he negates the main points in the withdrawal agreement with the EU and that he will try to renegotiate it - or run the risk of a no-deal exit. EU chief negotiator Michael Barnier has once again made clear that the EU excludes re-negotiating the agreement. The critical issues remain the same, something Johnson is well aware of. Especially the Irish border remains the stumbling block. May has already failed to solve this dilemma. And Johnson is unlikely to fare any better unless he turns out to find a solution to please all sides that nobody else thought of beforehand. Not very likely.

This brings back the scenario of a no-deal Brexit. According to a study of the Bank of England in November, this could mean a notable economic slowdown, a sharp fall in property prices and a hefty downward correction in sterling. The market has never really bought the idea of Central Bank Governor Mark Carney that the key rate might rise more quickly than currently priced in, although he has tried to convince the market several times since the last BoE meeting at the beginning of May. Granted, this is based on a soft Brexit scenario. But in times when other big central banks like the Fed and the ECB are shifting towards a more dovish approach, Carney's words become even less convincing. 

Consequently, the market will continue not to buy Carney's words but rather price in even more rate cuts.

At least, there are other candidates hoping for becoming the new Prime Minister. But Michael Gove is in trouble himself after reports about his prior cocaine use. Foreign Secretary Hunt, like Gove, does not rule out an extension of the Oct 31st deadline and rather supports a soft Brexit. But probably Johnson will likely set the tone during the next days. And this means trouble ahead for sterling.

OTC updates: Jump in GBP risk reversals (a move that was certainly overdue, given the Brexit risks) served as a trigger starting an erosion of the low-vol environment. The hefty jumps in many spot FX rates might be the final blow to this market situation.

Political stability is relevant for a reserve currency but if the experience of GBP is anything to go by this quality may be rather over-rated and the dollar rather less vulnerable than is commonly supposed to the influence of an iconoclastic president, even one who could yet serve two terms. 

Please be noted that the positively skewed IVs of GBPUSD of 3m tenors signify the hedgers’ interests to bid OTM put strikes upto 1.22 levels (refer above nutshells evidencing IV skews). 

As both interpretations make sense they are balancing the spot market and GBP spot levels are reacting hardy at all. 

It remains more expensive to hedge against strong GBP depreciation, which means that an orderly Brexit in whatever shape is still seen as being more likely. However, the risk of things going wrong is high and as a result, we regard any GBP appreciation with much skepticism. 

Although you are seeing risk reversals show neutral bearish risk reversal setup, to substantiate this downside risk sentiment, risk reversals have still been in negative territory in the long-run. Courtesy: Sentrix, Saxo & Commerzbank

Currency Strength Index: FxWirePro's hourly GBP spot index is flashing -37 (which is mildly bearish) at 10:23 GMT.

For more details on the index, please refer below weblink: http://www.fxwirepro.com/currencyindex