FxWirePro: Time To Bid Adieu For UK, But Sterling’s Dust Yet To Settle – A Quick Risk Reversals Analysis of GBP

Is this time for bidding adieu for sterling, because tonight is the night when the UK leaves the European Union after 47 years of membership. At that point the transition period will start, during which everything will initially remain the same, apart from the fact that the UK is no longer represented in the EU institutions and therefore has no voting rights. However, the horse trading is only just about to start, as the future relations between the EU and the UK will have to be negotiated over the coming months. If a (one-off) extension of the transition period was to be agreed the vote would have to be taken in July otherwise the risk of a hard Brexit at year end would rear its head again if a trade agreement cannot been reached by then.

As Boris Johnson has already made clear that sovereignty is more important than frictionless trade and that Great Britain will not be a “rule taker” to get the best possible deal from the EU doubts are justified as to whether the negotiations will be quick. A familiar face and politician experienced in negotiating with the UK, Michel Barnier, warned like many other EU officials before him that the negotiations will take more than 11 months, which really makes an extension of the transition period unavoidable. There is one interesting detail though that will make a possible extension difficult: a bit of legislation passed by UK Parliament prevents a Minister of the government to agree to an extension so that it is in effect not legally possible for the UK to ask for an extension.

In other words: the subjects are far-reaching, the positions very varied and time in short supply. So anyone hoping that Sterling might be out of the woods might be bitterly disappointed. Unwise to bet on GBP volatility remaining as low as it is once the negotiations start (probably in March) and make even the most optimistic participant realise: it’s not going to be that simple. Perhaps the currently low volatilities constitute a good opportunity to hedge the painful side at good levels again.

The above chart illustrates the divergent fates of GBPUSD and GBPJPY risk-reversals this year. Short- dated (1M – 2M) GBPUSD skews that used to be priced at a steep premium for GBP puts before last December's UK elections have now flipped positive in favor of GBP calls (1M +0.35, 2M +0.10), driven by heavy directional demand for GBP calls in the lead up to the January 31 Brexit date. In contrast, GBPJPY risk-reversals in similar expiries continue to heavily favor GBP puts (1M -0.95, 2M -1.25). The spread between the two, which can be crudely thought of as a synthetic USDJPY risk-reversal (the GBP legs 'cancel out’) is now near a range high of 1.4v, slightly wider than USDJPY skew itself. If one favors a short Yen risk-reversal stance in its own right, then this GBPUSD – GBPJPY riskie spread is too wide and is likely to compress going forward. Even if it does not, a long / short skew spread is likely to net earn positive smile theta while being insulated from Brexit politics. Courtesy: JPM & Commerzbank