Which UK fundamentals to weigh long term hedging risks ahead of BoE in conjunction with Brexit

Although sterling attempted jump above 1.4385 during earlier this month, but off-late surrendered those highs against the dollar as Brexit uncertainty returned to the fore.

A poll showed the ‘out’ side with a lead ahead of the June 23rd referendum on Britain’s EU membership. The spectre of an EU without Britain, and vice versa : could be equivalent to negativity for a EUR and GBP currency crosses. 

In addition to that, UK current account deficit is larger than it has been any time since 1985, a record low of -28833 GBP Million in the fourth quarter of 2014.

Tail risk of Brexit caused spike in demand for GPB downside (puts) over USD.

Risk reversals: demand for GBP puts/USD calls have spiked on fears of UK exit from the EU.

We expect the Fed to keep the funds target rate unchanged at 0.50% at this week’s FOMC meeting which is announced shortly.

While the likelihood  of the significant  'brexit' will likely keep pressure on the UK currency through the foreseeable future, while key events in the week ahead could force significant short-term volatility.

Nevertheless, the outlook for UK industry is poor with manufacturing currently expanding at the slowest rate in nearly three years, according to the latest manufacturing PMI survey.

We look for a slight rebound in the net balance of order books to -13% in March from -17% in Feb.

Notably, the export business declined for the second straight month in February while job losses were also realised.

The silver lining is that responses were collected before the sizeable sterling depreciation at the end of Feb, which could help the index recover in the near future.

European markets were tamed with the possibilities of a Brexit, now in the hands of British voters, and the Euro Stoxx 50 finished down 1.5% for the week.

We  predict the BoE will leave its Bank Rate and Asset Purchase Target levels unchanged. Barring a truly shocking result, the focus thus shifts to the official statement to follow the announcement.

What is weighing on the pound, the survey showed that the chances for the BoE to lower interest rates in 2016 had grown to 23%, up from the February survey that had placed the odds at only 10%.

For now, we would still recommend a GBP/USD 3M risk reversal i/o 1Y as a generic hedge for Brexit risk. The ideal entry point is not ideal given the near doubling of the risk reversal since early October, but the bias is for further widening of the skew in 1H on slow-bleed demand for event protection.

Option traders could continue extend bearish stances via short vertical spreads, using both call and put spreads.