FxWirePro: GBP options markets continue to price-in Brexit deadlock and other vulnerabilities

After yesterday’s weaker than expected, UK services PMI reading, the GBP and UK yields have been observed under pressure ahead of the BoE tomorrow. We have no data today, with PM May in Northern Ireland for a second day. Yesterday, she said that while a changed ‘backstop’ was a key issue in the Brexit process, she retains an ‘unshakeable’ commitment to avoiding a hard Irish border. Moreover, while she believes that technology can play a part on the border, it must be workable.

FX market participants with GBP exposure are not very interested in statements about likelihoods. All outcomes are sufficiently likely to require participants to be prepared. The speculative market participants whose portfolios are widely diversified and who therefore can apply probability statements stand to attention ready to bet on the GBP recovery, which can be expected in case of a constructive outcome. 

However, that should not prevent the market from reflecting the changing likelihood of “no deal” proportionately in the GBP exchange rates. That does not happen the whole time, and when it does happen it happens in bursts – as was the case yesterday when Sterling eased on the back of not-so-surprising PMI data. Does that mean that the no deal risk is reflected adequately in the GBP exchange rates this morning? Even the asymmetry of the risks is priced into the exchange rates to a very limited extent with 3M 25-delta risk reversals around 1.50 percentage points (given that 3M ATM vol trades around 10.1%) compared with the market reaction following the Brexit referendum in 2016. 

The fresh negative bids in the shorter tenors have been observed to the bearish risk reversal atmosphere in the GBP OTC markets, this is interpreted as the hedgers are keen on bearish risks in the broader perspective.

You could easily make out that the positively skewed IVs of GBP have been stretched out on the downside. Mounting bidding for OTM puts is interpreted as the hedgers’ interests for the downside risks (refer above nutshells).

It is tough to believe either that the UK would be suffering any food shortages in case of “no deal” and expect that Brits will still be able to fly to Spain for their vacation trips. Anyone banking on horror scenarios is likely to fall flat on their face. 

However, it is likely to be days or weeks between the news that there is going to be a no deal Brexit and the realization that even in that case Great Britain is not going to be swallowed up by the ground. Quite a few analysts consider the GBP weakness during this time frame to be sufficiently priced in. Courtesy: Sentrix, Saxo & Commerzbank

Currency Strength Index: FxWirePro's hourly GBP is at -28 (mildly bearish), hourly USD spot index is inching towards 114 levels (bullish), while articulating at 14:49 GMT. 

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