After another two weeks of UK and EU trade talks, last week’s EU summit ended with little more than both sides committing to work together. In isolation, that seems relatively positive – both parties had pledged to walk away if an agreement had not been reached long before this point. So, the fact that both sides feel further negotiation is worthwhile implies that there is a strong belief (and desire) that a positive outcome can be reached.
This appears to be the conclusion the currency markets have reached. Although sterling’s price action has been noticeably ‘choppier’ over the last couple of days, the pound remains broadly unchanged, trading just below $1.30 and €1.10. After peaking at 12.4% during mid-September, implied volatility has fallen back to 11.5% over the past month (see chart below). From a big picture perspective, this is still elevated compared to what we have seen in recent months (the average since the beginning of June has been 9.4%) but it also suggests that the market is not panicking about Britain leaving the bloc without a deal.
Chart 1: 3-month GBPUSD Implied Volatility
We now find ourselves asking, ‘is the market overly complacent, or are the headlines overly pessimistic?’ In short, the answer is probably a bit of both. Despite both sides agreeing to continue working together on a deal in the weeks ahead, the EU Council released a statement suggesting that it is up to the UK to make the necessary moves to make an agreement possible. Meanwhile, Boris Johnson countered by saying that the UK is now preparing for an Australian style agreement (basically no deal and reverting to WTO rules). That suggests to us that little progress has been made in recent weeks and talks have now reached stalemate. If this is the case, the market is under-pricing the risk.
Either way, discussions on State Aid, Fishing, and the role of the European Court of Justice are likely to be ongoing until at least mid-November. At this point, a conclusion needs to be reached (if a deal is to be struck) to provide enough time for legislation to be drafted before the end of the transition period on 31st December.
It is clearly still in both sides’ best interest to agree a deal and thus we remain optimistic that an agreement can be reached. We have previously suggested that the probability of a deal / no deal is around 50:50. Given that the end of the transition period is fast approaching, we feel that the balance is tilting slightly towards no deal, but for now, still only marginally. This is also reflected in the betting market odds where the bookies’ pricing now suggests around a 50% probability of a deal (from 60% a couple of weeks ago).
One point that remains very clear however, is that in the event of ‘no deal’ the downside risks to sterling are far greater than the potential upside, should a deal be reached. This is evidenced by the skew in the options market where the price of a 25 delta GBP Put (i.e. the cost of protecting against a move lower in GBP) is notably more expensive than a 25 delta GBP call (i.e. the cost of protecting against a move higher).
Chart 2: GBPUSD 3-month Risk Reversal
Our view remains unchanged. In the event of ‘no deal,’ we expect GBPUSD to move sharply lower to $1.20 (GBPEUR down to €1.02). If, however, a deal can be reached before the end of the transition period, we see scope for a relief rally in GBPUSD towards $1.35 (GBPEUR up to €1.15). Obviously, the latter will be influenced by the details of the agreement, but at this stage, anything that reduces the negative impact of no deal on the UK economy is likely to be seen as a positive (at least in the short term).
Author: Marc Cogliatti