FxWirePro: Brexit Hedging Intricacies - Sterling in High Spirits on Lingering Optimism of Brexit With Deal, But Prolonged Bears Beams-up With Scepticism

Sterling appears to be optimistic of upside traction of late. It is trading at almost the same levels against the euro as seen in May 2017. The reason is the very real hope of a happy end, i.e. a Brexit with a deal, even if it was to come after a delay. So how will things move on from here? Until 12th March Prime Minister Theresa May will have to present a (possibly slightly modified) deal that has been agreed with the EU. If Parliament passes it, we have reached a happy end and we will just wait for the final credits. If Parliament rejects the proposals, there will be a vote on 13th March as to whether the House of Commons supports a Brexit without the deal. 

If the answer is yes then on 29th March we will see what almost everyone is terrified of: the jump over the cliff edge into the no deal abyss with Sterling the following suit. 

However, we remain cautious and am only going to actually believe it once the deal is done, while my admiration for May’s achievements will be limited one way or the other. 

To justify GBP strength the risk of a no deal Brexit would have to fall significantly, if not disappear altogether. That is not the case as a result of May’s announcement yesterday. However, what seems decisive for the FX market, for now, is that May – once again – caved in. 

The fact that May caved in does make it more likely that at the end of a possible extended deadline she would cave in again if a majority in the House of Commons and a considerable number of her Ministers put pressure on her to prevent a no deal Brexit at any cost. If that is going to happen at all, as one of the most outspoken Brexit supporters, Jacob Rees-Mogg, signaled this morning that the euro-skeptical European Research Group might accept May’s Brexit compromise despite the Irish backstop to prevent Brexit from being postponed further or even being canceled. 

As a result, we continue to warn against losing sight of the residual risk of Brexit going wrong. In view of the currently prevalent optimism, the GBP reaction to an unexpected rekindling of no deal risks would be even more pronounced. Anyone who would consider this to constitute an existential risk is therefore urgently advised to maintain sufficient levels of hedging.

For hedging intentions, the potential of applying relative-value analysis obviously depends on the specific FX-sensitivities a given institution is exposed to.

GBPUSD risk-reversals screen as overvalued for the three base currency cases considered, given the uncertainty concerning the Brexit process, with just one month to go to the 29th March expected deadline, we find that a skew premium is perfectly justified, and we stay away from the temptation of fading the short-dated skews just based on this analysis. Conversely, the premium embedded in GBP risk-reversals would offer UK-based asset managers the opportunity of hedging their foreign assets via long GBP calls / short GBP puts constructs. Courtesy: Sentrix, JPM & Commerzbank

Currency Strength Index: FxWirePro's hourly GBP spot index is inching towards 142 levels which is bearish), while hourly USD spot index was at -42 (bearish) while articulating (at 09:22 GMT). 

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