The Pound Might be Calm for now, but Something Big is Coming

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Sterling has been incredibly well behaved since the news of a lengthy Brexit extension until October 31 was announced overnight.

Does this mean the end of the Brexit drama for Sterling?

For the time being, maybe the answer is yes.

"We’re quite comfortable with the muted-to-negative response in GBP/USD to the news of a Brexit delay until late-October," says Stephen Gallo, foreign exchange strategist with BMO Capital Markets in London.

But, looking to coming weeks the answer has to be a resounding no, if anything the market knows something big is coming but the uncertainty of just what that might be has paralysed the Pound.

Data from the options market - where traders buy and sell protection against unexpected future moves in a currency - shows a plummeting in expectations for future volatility in Sterling.

To be more accurate, there is no date around which market participants can place their orders to protect against adverse moves.

According to Reuters data, GBP option premiums took a sizeable hit before the EU summit as a 'no deal' Brexit was priced out by traders.

This apparently "signals calmer GBP climes expected as Brexit pressure eases," according to Richard Pace, an analyst on the Thomson Reuters currency desk.

The calm could however be misleading warns BMO's Gallo:

"There will be huge political fallout from a further Brexit delay. The tight ranges in EUR/USD and GBP/USD and the further compression in volatility (which is probably not over yet) partly reflect the fact that FX investors do not know how to quantify these political risks, nor are they able to estimate the economic effects."

Like a coiling spring, Sterling could in fact be a currency that is loaded and ready to be triggered in either direction, depending on the trigger.

A potential upside trigger could be the unexpected agreement of a Brexit deal between the Conservatives and Labour, with a cross-party agreement likely to see the Brexit deal ratified by a deeply divided parliament.

Surely the penny must soon drop that the time for compromise by all sides has finally arrived?

An optimist would take this view.

But judging by the sheer stubbornness of MPs on either side of the House, we remain sceptical. We are therefore more inclined to suggest the risks to the downside outweigh the risks to the upside.

"Uncertainty over what happens next remains high. Our view is that Conservative-Labour cross-party talks are likely to fail," says Roberto Mialich, a FX Strategist with UniCredit Bank in Milan, who says a general election is now likely. "An election will still pose many problems and may not solve anything. For these reasons, it can be still negative for Sterling in the near-term."

"Near-term, we monitor the response in the UK," says Mikael Olai Milhøj, an analyst with Danske Bank. "The Conservative backbenchers want to get rid of Theresa May."

The big risk we feel is a resignation by Prime Minister Theresa May, and a thumping at impending local elections might just convince the PM the time to step aside has arrived.

"While Conservative Party rules say there cannot be another no confidence vote in May's party leadership until December, the leaders of the Conservative backbenchers (the so-called 1922 committee) decided yesterday they will try to persuade May to quit soon. A bad local election on 2 May or bad European elections on 23 May may be what is needed to force Theresa May out," says Milhøj.

So while Sterling markets might look a sea of calm at present, undercurrents to rougher waters lie beneath the surface.

"Though 'no deal' cliff-edge risks have been delayed, they have been swapped for domestic political cliff-edge risks in the form of leadership changes and snap elections," says Gallo.

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