What Charts Say About the Pound’s Brexit Test

  • Volatility, risk reversals show investors seeking protection
  • Sterling’s weakness is underpinning front-end inflation swaps

Is There More Downside for the Pound?

As the pound’s losses deepen before U.K. Prime Minister Theresa May’s key speech on Brexit, charts showed heightened concern over more short-term declines.

Investors have pushed sterling toward a three-decade low after the Sunday Times reported that the premier will announce a plan involving an exit from the single market. Government officials said they expected May’s speech on Tuesday to cause a further “market correction.” Option prices and inflation metrics show investors are gearing up for more turmoil in the currency.

"It is a very political and random week, so volatility is justified," said Aurelija Augulyte, a macro strategist at Nordea AG in Copenhagen.

The pound’s volatility surface versus the dollar -- the depiction of the currency’s implied volatilities as a function of strike price and time to maturity -- shows elevated risks surrounding May’s speech. Hedging costs are much higher in the shorter term than in the longer run, with the premiums surprisingly lower for volatilities that cover March -- the time set for the actual triggering of Article 50 of the Lisbon Treaty -- than those that cover any eventuality before then.

Risk reversals, a gauge of market positioning, show that investors are the most bearish on the pound in almost three months. Investors are paying about 140 basis points more for a put option on the currency than for a call option. The spread was about 900 basis points in favor of puts in the run-up to the Brexit vote.

Sterling’s weakness may continue to pressure inflation higher. The U.K.’s two-year zero-coupon inflation swap, a gauge of market-implied price expectations, has risen about 100 basis points to 3.60 percent since the Brexit vote. That is three times the actual headline inflation rate for November, with many economists expecting the price gauge to approach 3 percent later this year. Consumer spending has remained resilient in the aftermath of the Brexit vote, but faces a real-income squeeze, with the household savings ratio now at the lowest level since the 2008 financial crisis.

Inflation swaps may be underpinned by the risk of higher import tariffs for goods and services from the European Union, and will require a rally in sterling, a collapse in oil prices as well as an increase in inflation-bond supply to adjust significantly lower.

The U.K.’s current-account deficit widened in the third quarter as Britain posted its worst trade performance in almost three years. The difference between money coming into the U.K. and money sent out was 25.5 billion pounds ($30.7 billion), equivalent to 5.2 percent of GDP. The trade deficit widened to 2.8 percent, the most since the fourth quarter of 2013.

"The current-account deficit is increasing the pound’s vulnerability while higher U.K. inflation means an appreciation of the currency in real terms," said Petr Krpata, a currency strategist at ING NV in London. This means that there could be less pressure on the GBP spot to rebound excessively over the medium term. Depending on Brexit-related news flow, he expects the pound to fall toward 1.15 against the dollar in the coming weeks and months.

Still, while a number of banks have revised their pound forecasts downward in the past week, there is little by way of consensus for its likely trajectory. Year-end estimates in a Bloomberg survey range from $1.09 to $1.38. The median forecast is at $1.25, which implies a 3.5 percent rally from the current level. The most bearish forecast would leave the pound at its weakest since 1985.

— With assistance by Stefania Spezzati, David Goodman, Tanvir Sandhu, V Ramakrishnan, and Vassilis Karamanis

    Before it's here, it's on the Bloomberg Terminal.
    LEARN MORE