FxWirePro: GBP/JPY Short Trades Radar on Brexit Turmoil

We wish to reinstate short positions in GBPJPY this week as we reckon that Sterling has taken its eye once again of the no-deal ball. 

While the GBP NEER now trades close to its 1Y average. This under-discounts the risk of an eventual no-deal (conditional probability of nearly 40%) and we consequently fade this week’s optimism on the Johnson plan by selling GBPJPY. And staying short in GBPCHF although a cable put spread expired OTM. 

For now public attention focuses on the question as to whether a Brexit deal is possible by the end of the month. The chances of that are obviously low. What is more important is the question of what happens if no deal has been reached by 19th October.

PM Johnson meets with Irish Premier Varadkar to try to find some common ground and move towards a deal around the contentious Irish backstop (the Government has asked Parliament to sit on Saturday 19thOctober – after the EU summit).

Already released data today, showed trade war pressure again with Japanese machinery orders, French industrial production and German exports all weaker than expected.

At these levels we suspect GBP once again materially under-discounts the risks of a disorderly no-deal Brexit. Some economists put the conditional probability of this outcome in January 2020 following an early election at nearly 40%, so making it the modal scenario. We have long argued that GBP is nowhere close to discounting this worst-case scenario even though the REER is 14% cheaper than its two-decade average – the economic dislocation following a no-deal could resemble the banking crisis for a couple of quarters. And against this backdrop GBP is liable to encounter severe balance of payments strain – not only would the 4% of GDP current account deficit likely go unfunded for a period of time, there is the risk of outright repatriation of the sizeable foreign capital residing in the UK (UK gross foreign liabilities of circa 4x GDP). 

The optimism that initially greeted the publication of PM Johnson’s Brexit proposals this week has already started to fad. Even so we believe it worthwhile increasing our bearish beta to GBP through re-selling GBPJPY (our single most successful trade to date this year). The lead- up to the EU summit on October 17-18 will become increasingly fraught from a political perspective. Johnson may well apply for an extension but that won't buy GBP any real breathing space - all it would do is create the space for an early general election which on the basis of the current opinion polls Johnson would narrowly win. Our current guesstimate is that there is a two-thirds chance of a new Conservative government with a de facto hard-Brexit mandate. In turn, there is perhaps a 60% chance of Johnson leaving with no deal by January next year. Together that gives a near 40% conditional probability of no deal, an uncomfortably high probability for GBP, in our opinion. 

Stay short in GBPJPY cash at 131.619 for targets 130 stop at 132.50 levels.

At spot reference: 131.619 levels, contemplating above geopolitical drivers, one can execute tunnel options spreads using upper strikes at 132.544 and lower strikes at 130 levels. Such exotic option likely to cap upside movement and favor prevailing selling sentiments and fetch leveraged yields as compared to spot.

Alternatively, amid Brexit decision shorting futures of mid-month tenors are advocated on hedging grounds with a view of arresting further potential slumps. Writers in a futures contract are expected to maintain margins in order to open and maintain a short futures position. Courtesy: JPM