FxWirePro: Sterling Hedging Perspectives of Tail Risks After UK Polls

Boris Johnson won the elections he wants things to be move ahead very quickly as far as Brexit is concerned. The new government will present the legislation required for a ratification of the exit agreement for a second reading to the new Parliament on Friday. Due to the Conservative’s large majority in the House of Commons it is generally assumed that the official exit process will go smoothly by the deadline at the end of January. 

Although GBPUSD appears to be signs of recovery, reversal for the major downtrend needs better clarity. You could still make out GBP hedging sentiments for bearish risks in FX OTC markets though there are minor shift risk reversals.

Since the Brexit referendum and the 2016 US election, the two major upsets during the turbulent 2016, FX option markets have been sensitive on the issue of political event risk premium. The upcoming 2020 US election pricing are gearing to be one of the most eventful in history and as one possible driver capable of breaking the fragile state that global economy lies in at the moment. 

OTC outlook: The positively skewed implied volatilities of 3m tenors have still stretched towards OTM put strikes that indicates the hedging sentiments for the downside risks amid the minor positive shift in RRs.  

To substantiate the downside risk sentiment, risk reversals have still been signalling bearish hedging sentiments despite some positive shift is observed in the bearish risk reversal numbers in the shorter tenors. Hence, we advocate below options strategy on both hedging and trading grounds.

Strategy (Debit Put Spread): Contemplating above factors, wise to stay short sterling via a limited loss tail hedge: Stay short a 2M/2W GBPUSD bear put spread (1.3425/1.27), spot reference: 1.3205 level. 

The Rationale: Brexit might take a backseat as far as Sterling is concerned over the coming months - at least until an extension of the transition period becomes more urgent. Instead focus is likely to turn to the fundamental situation in the UK. The surprisingly weak PMI published yesterday did not constitute a good start in this respect. 

What is decisive is how the economic data develops from now on, what would be particularly important would be to find out to what extent the recent weakness of the British economy was due to the Brexit uncertainty, to the trade conflict or even structural factors. If the real economic weakness was to be deeper and therefore longer term this would constitute an ideal breeding ground for rate cut speculation which might weaken Sterling at least temporarily.

We perceive the conservative majority is to likely translate Johnson’s deal into UK legislation in a manner which raises no deal risks at end 2020 as a Conservative majority will bring with it a temptation to reopen the deal to address Brexiteer concerns. Conveniently, the trough of GBP term structure is currently at 1Y tenor, making an outright 1Y to 18M vega ownership attractive. 

From the GBP OTC outlook, amid major downtrend we reckon that the sterling should not suffer like before, but, one should not disregard the UK elections and Brexit settlement risks on the other hand. The market has always ignored the fact that all the current BoE interest rate moves are due to a favourable result of the Brexit process. Courtesy: JPM & Commerzbank