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GBP has been a currency with substantial fundamental uncertainty for now in our view. One side Brexit transition and on the other hand, the abrupt change in the BoE’s reaction function triggered a sharp GBP rally in September. However, the trigger for the shift remains unclear and injects a greater-than-usual degree of instability to the path of UK monetary policy.
Politics remains a risk factor for the currency, both at a domestic level where speculation around PM May’s grip on the Tory party and a potential leadership challenge has increased and externally on the Brexit front where the risk of deadlocked UK/EU negotiations going into the December summit and a UK walkout has grown.
These risks are not mutually exclusive either, with a messy feedback loop from Brexit politics to BoE policy potentially exacerbating bearish currency pressures, widening the range of possible outcomes and imparting a fat left tail to the distribution. Yet current levels of GBP implied vols/skews price in almost no policy uncertainty premium.
A simplistic pointer is that GBP ATM vols and skews have retraced more than 100% of their post-Brexit referendum widening from last year even as the pound has reset at a permanently weaker level. A more robust argument is that current GBP vol levels are consistent with zero risk premium in the spot, where the latter is measured as the undershoot relative to a pure interest rate based cyclical framework.
As per the above charts, it demonstrates, the risk premium for policy uncertainty in the currency – both in cash and in vol –is near zero, and this is surprisingly equally, if not more, true for low-delta risk reversals that generally act as reliable repositories of tail risk premium. Thus, it is reckoned that the UK policy uncertainty inadequately priced into GBP options. Courtesy: JPM
