Pound Nervous Ahead of Key Salzburg Summit

Image © European Union 2018 - European Parliament, Reproduced Under CC Licensing.

- Salzburg unlikely to deliver Brexit breakthrough

- Currency markets still hedging against talks failing

- Sterling seen losing ground as 'good news fuel' runs dry

Pound Sterling is seen easing back on global currency markets midweek amidst signs that markets are nervous a recent run of good news concerning Brexit is now fully priced into the currency.

The Pound has rallied over recent days amidst signs of progress in Brexit negotiations; however we hear reports that further substantial developments are unlikely to come from this week's meeting of EU leaders in Salzburg, and this has taken some wind out of the Pound's sails.

EU leaders gather in Salzburg for a two-day summit starting today.

The Pound-to-Euro exchange rate is seen at 1.1247, having been as high as 1.1277 earlier in the day, the Pound-to-Dollar exchange rate is seen at 1.3159, having been as low as 1.3175 already today.

News that Salzburg won't deliver more good news on the state of negotiations will certainly disappoint bulls who had this week eyed the event as being a key one in terms of Brexit negotiations.

"This week's European Union summit is informal, with no concrete decisions or declarations, so headline risk is likely to be a matter of interpretation: is a Brexit deal more or less likely? That should limit GBP volatility, especially of the magnitude seen over the past week or so," says Richard Pace, an analyst on the Thomson Reuters currency desk.

Pace says a lack of demand for short-dated GBP options heading into the summit reinforces that view.

Typically, when markets sniff the potential for big moves in a currency around a given event they will look to buy foreign exchange options to protect against, or profit on, volatile moves in the currency.

"Shorter-dated GBP/USD implied volatilities hit six-month highs early last week as the spot volatility surrounding more optimistic Brexit headlines and GBP short covering rewarded those holding long gamma options," says Pace.

Pace notes those options sold off toward the weekend as GBP settled and dealers booked profits.

"Deeper volatility declines look unlikely going into the summit, but the lack of demand so far this week is telling. One-week GBP/USD implied vol at 8.0 is 2.5 volatilities below last week's peak and 120 pips versus 153 pips break-even for the at-the-money straddle," adds Pace.

This week we have seen further progress on the matter via a more constructive approach to the Irish border question from the EU which hints that the key sticking point to securing a Withdrawal Agreement by November might be surmountable after all.

That markets are not demanding option contracts heading into Salzburg suggests markets aren't nervous, and we wonder if they might be guilty of complacency.

Sterling has shown an ability to move sharply on the slightest bit of good news from sources that are considered reliable, therefore we are very much aware that Salzburg could yet deliver unexpected volatility.

Advertisement
Lock in Sterling's September recovery: Get up to 5% more foreign exchange for international payments by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here

Traders Still Wary of a Big Dip

Optimism that a Brexit deal can be reached has bolstered the British Pound over the course of September, ensuring it is one of the better-performing global currencies.

The Pound-to-Euro exchange rate opened the month at 1.1161 and has rallied to a high of 1.1270. The Pound-to-Dollar exchange rate opened the month at 1.2969 and is now quoted back above 1.31.

Despite progress in Brexit negotiations, markets remain wary that talks will go down to the wire and therefore disappointment for those wanting a stronger British Pound is still likely as both sides push their hand in order to try and eke out further concessions.

This leaves the prospect for damaging volatility in the Pound exchange rate complex high.

The high cost of hedges to protect against a slump in Sterling confirms the perceived risk of Britain crashing out of the European Union with no deal is still high and therefore the gains are by no means secured.

"The significant uncertainty surrounding the UK’s life outside the EU – and the prospect of a ‘no-deal’ exit - is reflected in the defensive positioning in the derivatives market where GBP puts continue to attract a premium over calls across the forthcoming Brexit timeline," says Neil Mellor, a Senior Currency Strategist with BNY Mellon.

Pace confirms longer-term expiry risk reversals (six-month through one-year), which show the implied volatility premium for GBP puts (downside) over GBP call (upside) strikes, remain elevated.

Thomson Reuters data shows the one-year risk reversal, which expires after Britain's scheduled 29 March 2019 departure from the EU, remains elevated near recent and long-term highs of 2.0 volatilities for GBP 'puts'.

'Put' options deliver returns to the holder when an asset decreases; in this case the holder will be in profit if the Pound falls.

"Outright demand for GBP 'put' options has certainly slowed in recent weeks, but the high risk reversal bias in longer dated contracts shows the cost of hedging a GBP slide is little changed," says Pace.

What most foreign exchange analysts are however certain of is that there is a huge amount of recovery potential in Pound Sterling once the big breakthrough in talks is delivered and a 'no deal' Brexit is avoided.

Advertisement
Lock in Sterling's September recovery: Get up to 5% more foreign exchange for international payments by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here