Pound Sterling Feels the Heat as Investors, Corporates Pile into Downside Protection Hedges

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- Currency hedges blamed for Pound Sterling's recent underperformance

- Brexit deadlines are now close enough to hedge

- JP Morgan say they are staying 'short' on Sterling over coming weeks

- If markets continue to focus on buying protection trades Sterling will struggle say Bank of America

Traders are buying downside protection to protect against negative Brexit outcomes, and this is what is really weighing on the Pound.

Analysts believe the Pound will remain under pressure against rivals over coming months as markets eye the UK's March 2019 Brexit date and buy protection against a substantial move lower in the Pound in the event of no deal being reached.

"We have emphasised that markets prefer to deal in definitive deadlines in order to anchor their views and believe that with the 29th March 19 Brexit date now visible on the horizon, that investors are taking this opportunity to buy protection," says Kamal Sharma, European head of G10 FX strategy at Bank of America Merrill Lynch. "We do not think that that market has taken a fundamental view on the outcome of the Brexit negotiations since this would have led to a significant move in GBP."

The UK is set to depart the EU on March 29, 2019 but it is far from certain whether this departure will be an orderly one.

October's European Council summit meanwhile marks a soft deadline for progress in the talks as it is seen as the last viable opportunity for national leaders to approve a withdrawal agreement with enough time left over for it to be ratified in all parliaments across the European Union.

Therefore, we have a number of dates that are now close enough for a good portion of the market to buy currency products that will guard against the negative consequences of a fall in the Pound in the event of a 'no deal' Brexit.

But, the buying of this downside protection means a good supply of Sterling offers onto the market, which in turn pushes the value of the currency lower.

Sharma notes how the Pound fell steadily from 1.70 against the Dollar in late 2015, to 1.20 in October 2016, with just less than half of this loss occurring before the actual referendum.

Those losses were caused in large part by hedging flows resulting from market unease over the looming referendum.

Sharma suggests the same phenomenon could be playing out again in the run up to the UK's March 2019 exit date.  

Richard Pace on the Thomson Reuters currency desk notes "the uncertainty surrounding Brexit has been fuelling demand for cable options in recent sessions, with a notable increase in premiums for GBP put (downside) protection."

Alvin Tan at Société Générale however suggests implied volatility in Sterling crosses are not particularly elevated - i.e. markets are not buying hedges to guard against sharp rises or sharp falls in the near-future as has been the case in the past.

Therefore, there is potentially sizeable scope for the market to increase its buying of downside protection, which would only weigh on the Pound further.

"The Brexit news flow may subside as Parliament heads into summer recess next week but not even an August rate hike may be enough to help the near-term outlook for GBP if markets continue to focus on buying protection trades. As EU officials stated this week, the UK Government Paper is detailed but is unclear. This lack of clarity will not be conducive for GBP in the coming months," Sharma concludes.

Foreign exchange strategist Meera Chandan at J.P. Morgan says they continue to bet against the Pound in this environment.

"The political and economic backdrop remains supportive of GBP underperformance. We continue to be short but take partial profits by unwinding the GBP/USD expression of the trade since this is currently in the money but has only less than a week to expiry and is close to the strike," says Chandan.

The J.P. Morgan team have been betting against the Pound ever since around the beginning of July.

They have bought the EUR/GBP rate at 0.8860, which is the same thing as betting on a decline from 1.1286 in the Pound-to-Euro rate, and are also selling the Pound-to-Swiss-Franc exchange rate. Chandan recommended exiting a Pound-to-Dollar derivative trade this week after the underlying exchange rate fell close to 1% during July.

At the time of writing the Pound-to-Euro exchange rate is quoted at 1.1251, having recovered from monthly lows at 1.1160.

The Pound-to-Dollar exchange rate is at 1.3205 having been as low as 1.2957 this month.

Most analysts are however expecting a recovery in the Pound should the key dates being eyed pass by withough incident and server to offer more clarity on the future of UK-EU relations. 

"GBP is cheap both on a short-term (Bank of England and UK economy) and long-term (soft or 'status quo Brexit') basis. But the political chaos in Westminster makes it a good reason to trade at a discount," says Viraj Patel, an FX strategist at ING Group's London unit.

ING say that a "benign scenario" that would see an easing "of short-term political headwinds" would actually see the Pound recover back to these June highs with the Pound-to-Dollar exchange rate forecast to recover back to 1.35 and the Pound-to-Euro exchange rate back to 1.15.

"Yet, the difficulty with this is that we don’t see the stormy political clouds over Westminster lifting any time before October," says Patel.

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