Although there is clearly some ‘statescraft’ going on at the UK parliament this morning, Boris Johnson looks very close to securing the Brexit deal that he promised would happen before the October 31st deadline, as he claims to have sufficient parliamentary support (assuming the DUP is on his side with this new deal). If this is the case and we do see both the UK and EU parliament’s ratifying this new Brexit deal, what can we expect from the FX markets as it pertains to GBP? There are a few key areas which will give us some insight. The first is current market positioning, as this gives an indication of how players may react to cover or add to positions. Secondly comes the current market pricing and what we can glean from this, and finally we look at the other side of the equation, the USD and what is happening in the worlds largest economy which may give us some insight into the general trend of the USD.
What are the positions in the market?
Fast Money: Analysis from our friends at ex ante show us that the fast money (CTAs and hedge funds) has already been shifting from being short GBP vs EUR to being moderately long GBP vs EUR. However, in GBPUSD there are still many short positions in the market, so we expect GBPUSD buying should we see cable move higher after we have a clearer decision.
Real Money: Positioning indicators have pointed to moderate GBP shorts in recent months, although some of these positions may have been closed in the last week as the positive news flow hit the markets.
Long Term Players: Central banks had reduced allocation to GBP since the Brexit vote, and an outcome seen as being positive for the UK could result in a rebalancing back to previous levels, which would be supportive of GBP over the coming months.
What are the markets telling us?
Spot Price: GBPUSD has seen an 8.3% rally since the lows were hit in August. This is a significant rally, but is still only a recovery of a third of the sell-off experienced after the Brexit vote in 2016. There is still a LOT of room to move higher.
Chart 1: GBPUSD Spot
The first target level on the topside is the previous high at 1.3380, then the trendline resistance at 1.35, followed by the 2018 high at 1.3420, which is very close to our PPP fair value level of 1.3360.
Volatility Pricing: The volatility markets are telling us that risk continues to be reduced as we near a negotiated exit. Vols across the tenors have come significantly lower since the positive headlines started to emerge. Fear has definitely been reduced as uncertainty has been reduced.
Chart 2: GBPUSD Options Implied Volatility
Chart 3: GBPUSD Volatility Smile
But the volatility smile (the volatility one would pay for different strikes) shows us that there is still far more demand for GBP puts than GBP calls, so the market is not pricing a high likelihood of GBPUSD spiking higher from current levels on a positive outcome for Brexit. This is interesting to me as the spike we have seen has been impressive thus far.
Valuation: Even with the recent 8%+ rally in cable, GBP is still circa 10% undervalued vs the USD. Fair value based on our methodology, would see GBPUSD at a level of 1.4360.
The Big Dollar: Thus far in this edition of The Big Picture we’ve been focused on the GBP side of GBPUSD, but what’s happening with the US dollar in general?
We’ve seen a series of disappointing economic headlines out of the US, even though trade talks with China seem to be moving in the right direction. Here are just a few of the headlines which point to impending troubles in the world’s largest economy;
· US Corporate Debt Triggers Recession Concerns – Financial Times, 20 Oct 2019
· Lagarde Says U.S. Is At Risk Of Losing Global Leader Role – WSJ, 21 Oct 19
· Fed’s Bullard Warns Risks Remain High and US Economy May Slow More Sharply Than Expected – CNBC, 15 Oct 19
· US Retail Sales Unexpectedly Decline in a Sign That Consumer Economy Could Be Cracking – CNBC, 16 Oct 19
This shift towards greater concern for the US economy has coincided with a circa 2% decline in the trade weighted average of the US, as depicted by the US Dollar Index. So it’s not just GBP that has enjoyed an appreciation vs the US of late.
Chart 4: US Dollar Index
Conclusion, should Boris be successful in his (final?) push for a negotiated Brexit:
Taken all together, it looks like GBPUSD may be in for an extended rally in the coming months, assuming we see an adoption of the Boris Johnson-negotiated Brexit plan. However, should this fall through, with cleaner positioning and fears of the downside, we will see a very quick move lower in the GBPUSD pair.