Quantifying risks between BoE and Brexit, uphold short hedges

GBP has been a notable outperformer, albeit correcting lower in recent days as a May rate hike is called into question. Intra-month cable and the GBP NEER established fresh post-referendum highs, cable jumping three cents to 1.43 and the GBP NEER gaining 2.5% to halve the Brexit losses from a maximum of 16%.There is no single factor which explains this outperformance.

Instead, it reflected a combination of a fading of Brexit risks following the agreement in principle on a stand-still, two-year Brexit transition, confidence in the BoE’s tightening cycle, a mooted large M&A deal in the pharma sector, and unusually strong albeit opaque seasonal factors which likely encouraged traders to increase tactical GBP positions.

Indeed, speculative longs rose to virtually their highest level since before the financial crisis, a stark contrast with record shorts last year.

Despite the bullish price action, we remain circumspect about GBP’s prospects in view of a less than convincing macro backdrop characterized by underperformance in growth and outperformance in inflation (the forecasts are unchanged and envisage a broad consolidation in the GBP TWI over the coming year).

In the last few months, the FX market has been indifferent to weak growth, drawing comfort instead from the BoE’s resolute attitude towards policy normalization to address inflation. But in our view, the composition of nominal GDP growth does matter for GBP, not least because of the potential feedback loop from FX appreciation to inflation that could neutralize the pretext for extended tightening and so short-circuit the recovery in GBP absent faster growth. The soft CPI data for March data hinted at this risk as core inflation unexpectedly dropped to its lowest level in a year (2.3% vs. a peak of 2.7%).

More surprising and also damaging for GBP were the subsequent equivocal comments from BoE governor Carney that have caused the market to reprice a May rate hike from a near certainly to a coin flip and to push the follow-up rate hike back to August 2019. GBP has dropped a percent as a result.

Initiate shorts positions in the futures contracts of mid-month tenors with a view to arresting downside risks.

Writers in a futures contract are expected to maintain margins in order to open and maintain a short futures position.

Currency Strength Index: FxWirePro's hourly GBP spot index is inching towards -84 levels (which is bearish). While hourly USD spot index was at shy above 134 (bullish) while articulating (at 11:44 GMT).

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