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Albeit GBP risk bias is upgraded to positive as subsequent developments have been constructive on balance.
We think the chances of a fall that far are about 5%, whereas, by contrast, the chances of the GBPUSD reaching 1.50 are around 15%, reflecting the possibility of another election being called and speculation emerging in earnest, that the UK could see a second Brexit referendum. That is unlikely but not impossible and not definitely priced in by the FX market.
In particular, favourable progress on Brexit has overshadowed marginally discouraging macroeconomic trends as the UK economy risks being eclipsed by an increasingly powerful global uptrend.
The forecast essentially assumes that GBP's trade-weighted value will continue to drift within the sloppy 10% range that has prevailed since the Brexit vote.
But this masks a rather more divergent pairwise performance as we expect GBP to weaken by a few percent vs EUR to 0.92 by year-end.
With sentiment so gloomy towards sterling, no wonder it’s trading, in real terms, 13% below its average level of the last 20 (and 30) years. The pound’s trade-weighted value correlates with the EURGBP rather than the GBPUSD and if, as we expect, the EURUSD rises choppily through 2018, we will see euro strength push the EURGBP up and drag sterling towards its lows in trade-weighted terms. A move to new lows, with the EURGBP above 0.95, seems inevitable if we do see the EURUSD above 1.25, but we don’t expect to see the EURGBP trade at parity in 2018.
The fundamental motivation for owning GBP volatility was straightforward and colored by uncertainty on multiple fronts – around the Brexit process, increasingly dysfunctional domestic politics, continued debate around the abrupt change in the BoE’s reaction function and the risk of an unwind of rate hikes priced along the yield curve should growth and/or politics intercede.
With current levels of implied vols still low, we continue to find value in holding this trade.
Long a 1Y vol swap in EURGBP. Opened at 8.85%November 21. Marked at 8.15%.
