FxWirePro: “Unique and ambitious economic alliance”, Brexit transition at 5th round – Derivatives hedging vehicles for crippled sterling

What a difference a month has made to GBP in terms of immediate central bank prospects, if not the cyclical outlook for the economy or the complex interplay between UK politics and Brexit. The BoE caught the market off-guard at its September MPR when it signaled its intention to commence tightening in ‘coming months’. The curve had assumed that the BoE would be on hold until early 2019. The result: a dramatic rate re-pricing - a November hike is now 75% priced and two full hikes are discounted by the end of 2018 - and a 5% short-covering scramble in GBP, its second-best monthly performance since 2009.

There is one thing an FX analyst does not have to explain, and that is when Sterling is weakening. However, whenever the British currency does not ease, then that is something that does require an explanation. The Brexit negotiations are going far from well. Yesterday Prime Minister Theresa May defended her approach in Parliament.

We have heard the phrase about the “unique and ambitious economic partnership” many times - too many times! It is high time the Prime Minister addressed the concrete details. The FX market (and the British electorate) would like to know now what this phrase entails. At least more clearly than the government’s contradictory working papers have so far revealed.

Of course, a Prime Minister might not have to comment on every detail. The relocation of the Galileo ground control station may be an issue for her Ministers to decide. But questions like the free movement of goods and people on the Irish border should be issues managed right at the top.

The fact that she rants, instead confirms the prejudices of many observers: the British government seems to be out of its depth when it comes to the Brexit issue. That is relevant for the FX market as this more than encumbers the negotiating process and as the risk of accidents rises, the risk that the end result will turn out in a way nobody wants it to - and thus in a way that is GBP negative.

Sterling would also lose out against the euro in a scenario such as that. That is something the British government does not understand and many British people anyone talks to do not understand either: an agreement in the negotiations is not a matter of life and death for the EU Commission. On the contrary, they can gain support here on the Continent by remaining firm.

Hedging radar:

GBP OTC hedging sentiments are intensifying due to the above Brexit negotiations. Is this the beginning of the final phase bearish trend of the British currency? Not yet, but the risks are rising.

Considering above OTC market reasoning and fundamental factors we think upside risks are on the cards, as result we reckon deploying ATM call option with delta being at around +0.51 in hedging strategies are worthwhile.

We fundamentally view asymmetric odds in favor of the topside case, and this highlights the current cheapness of GBPUSD OTM calls.

The execution: Buy GBPUSD 6m/2m/1m bullish seagull strikes 1.27/1.38/1.34 (Spot ref: 1.3186).

This structure has almost no theta between the current spot and the 1.40 region during the four first months. As it is a very low theta means almost no convexity, it, therefore, behaves like a spot trade during this period in this region.

The payoff, however, provides protection against a spot spiking above 1.27.

Alternatively, encourage buying futures contracts of mid-month tenors in order to arrest upside risks.