Since the beginning of November, the pound has gained 4.2% against the dollar (rallying from $1.2855 to a high of $1.3398 yesterday). Looking across the G10 currencies, all have gained ground on the greenback indicating a broad theme of dollar weakness. Given the recent surge in risk appetite amid optimism surrounding the progress made by the large pharmaceutical companies on a COVID vaccine and incorporating the inverse correlation between the dollar and risk appetite, this should not come as much of a shock to our regular readers.
If we ignore the influence of the dollar and think about sterling’s performance against the euro, Brexit has been the driver. Although numerous deadlines have elapsed in recent months without any assurance that a deal will be forthcoming, most commentators remain optimistic that a deal can be agreed before the end of the transition period. The rationale is threefold:
- Comments from both sides have implied that negotiations have progressed, compromises have been made (by both parties), and a deal is close;
- Most people agree that a free trade agreement is best for both sides;
- If there was no chance of a deal, then what would be the point in ministers continuing with talks?
The obvious problem is that time is fast running out. Last week, it was reported that David Frost told Boris Johnson to prepare for a deal as early as this week but so far, nothing has been forthcoming. Talks ended abruptly after one of the EU negotiators tested positive for COVID, and while negotiations continue this week (in a virtual capacity) it seems increasingly likely that they will drag on into December. Given that a deal still needs to be passed by lawmakers on both sides, coupled with the fact that getting things done over the holiday season is always more difficult, we should not rule out the possibility of no deal, even if it only happens by accident. There has been a suggestion that allowances could be made for the ratification process to continue into the new year, if a deal is agreed before year end, but how that fits in with the current legislation surrounding the end of the transition period remains unclear.
What are the markets telling us?
The most obvious barometer of sentiment is the spot market, whereas discussed above, sterling has been steadily climbing against both the dollar and the euro in recent weeks. On a trade weighted basis, sterling is close to the highest level it has been at any point since the COVID related market turmoil started back in March (see chart below). One-point worthy of note is the steady gains made since the middle of September. Based on this, it is fair to say that the market is pricing in a high probability of a deal.
GBP Trade Weighted Index
Meanwhile, we saw a considerable fall in 1-month option volatility at the beginning of November (~12% down to ~10%). Once again, this would suggest that the market is relatively confident that a deal will be struck. On a slightly more cautious note, the risk reversal (the cost of protecting against a move lower in GBPUSD vs the cost of protecting against a move higher) has shifted lower. The chart below shows that the risk reversal moved higher throughout September, October and early November (i.e. the cost of a 25 delta put relative to a 25 delta call fell) but this has reversed slightly in the past two weeks. We would suggest this merely reflects the fact that because spot has rallied, the downside (in the event of no deal) is now far greater than the upside (if a deal is agreed).
GBPUSD 1-month risk reversal
At the beginning of the year (when GBPUSD was around $1.30) we set a target range of $1.30 – $1.35 for the pair if a deal could be reached. As we approach the upper echelons of that range, our target has not changed and although we see some short-term upside potential if a deal were to be announced, we do not expect a dramatic rally above $1.35. Clearly the bigger risk is to the downside, if a deal is not struck (primarily because this is now priced into the tail). Our downside target of $1.10 – $1.15 is not completely beyond the realms of possibility, particularly as we head into the new year, but at the very least, a swift tumble towards $1.20 would be likely in the very short term.
Author: Marc Cogliatti