Pound Sterling Options May Signal Further Volatility Amid Brexit Risk

The British pound has rebounded over the past week, but volatility may be set to continue as Prime Minister Theresa May signals for a hard exit from the European Union.

It has been a wild month for pound sterling. Last week, the GBP/USD exchange rate briefly fell below 1.20 for the first time since October’s flash crash. The drop was attributed to reports indicating that Prime Minister May was preparing to withdraw from the single market in return for retaining full control over immigration.

In a highly-anticipated speech on January 17, Mrs. May outlined in her clearest terms yet a plan to leave the EU.

“The United Kingdom is leaving the European Union, and my job is to get the right deal for Britain as we do,” she said. “What I am proposing cannot mean remaining in the single market.”

She continued: “We sell a new and equal partnership – between an independent, self-governing, global Britain and our friends and allies in the EU. Not partial membership of the European Union, associate membership of the European Union, or anything that leads us half in, half out.”[1]

However, May’s remarks included one important caveat: any Brexit deal would require approval from both houses of Parliament.

The British pound skyrocketed following the speech, a sign that investors felt approval from the House of Commons and House of Lords may be difficult to come by. The pound rallied nearly 3% against the dollar immediately after the speech, with the GBP/USD closing at 1.2388. That was the single biggest gain in eight years.

After a brief pullback on January 19, the pound padded its gains in subsequent sessions to trade at its highest level since mid-December. Leveraged funds have more than doubled their net short positions on sterling in January, according to data from the US Commodity Futures Trading Commission.[2]

However, analysts note that the pound may still be vulnerable to a sharp decline, given that the full realities of a hard Brexit haven’t been fully priced into the market.[3] There is considerable uncertainty about how a hard exit from the EU would impact the British economy. Combined with volatility negotiations, this environment may signal further downside for the British currency.

The pound has been caught in a death spiral since the UK voted to leave the EU in a June 23 plebiscite. Sterling has found a new home at 31-year lows against the dollar, and at one point crashed to a 168-year bottom against a basket of other major currencies.[4]

Another major risk for sterling is faster inflation, which may push UK real interest rates further below zero, according to the Commonwealth Bank of Australia. The Bank of England (BOE) has outlined its preparedness to accept above-target inflation as it eases monetary policy further. In August, the BOE slashed interest rates to a new record low of 0.25% and expanded the size of its monthly bond-buying program to hedge against Brexit-related risks.

Recently, one-month implied volatility in the pound climbed to its highest level since mid-October, as traders sought protection against the turmoil.[5]

Sterling has enjoyed some support in recent weeks by a declining US dollar, as Donald Trump’s protectionist stance challenged the conventional narrative that the world’s largest economy may grow under his leadership. However, the dollar and the pound may converge further in the medium term as the Federal Reserve gradually lifts interest rates while the BOE considers additional stimulus efforts. Fed policy may keep the greenback elevated against most other currencies at a time when central banks around the world are keeping monetary policy highly accommodative.

[1] Stephen Castle and Steven Erlanger (January 17, 2017). “In Brexit Speech, Theresa May Outlines Clean Break for U.K.” The New York Times.

[2] David Goodman and Masaki Kondo (January 15, 2017). “Sterling Options Signal More Turmoil as May Speech, Ruling Loom.” Bloomberg Markets.

[3] David Goodman and Masaki Kondo (January 15, 2017). “Sterling Options Signal More Turmoil as May Speech, Ruling Loom.” Bloomberg Markets.

[4] Mehreen Khan (October 12, 2016). “Pound slumps to 168-year low.” Financial Times.

[5] David Goodman and Masaki Kondo (January 15, 2017). “Sterling Options Signal More Turmoil as May Speech, Ruling Loom.” Bloomberg Markets.

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