After turning very bullish in our outlook for sterling at the beginning of March (in anticipation of Theresa May getting MPs to agree to a softer Brexit) we are now reconsidering our stance in light of the extension and ensuing uncertainty. For the record, we are not suggesting any dramatic changes at this stage, but it now appears very unlikely that GBPUSD will reach our target of $1.40 by the end of Q2 2019 and as such, see this as an opportune moment to review.

New Brexit timeline

23rd May – Although there is a slim possibility that Theresa May could win enough support in parliament to get her deal passed before this date, the high probability is that Britain will participate in the European elections. It looks to be a two-horse rate between Nigel Farage’s newly formed Brexit party and Labour for most seats, with the Conservatives expected to lag behind.

• 1st June – If the UK does not participate in the European elections, it will leave on this date (with or without a deal). Under the terms of the current extension, if at any point before 31st October, the UK and the EU ratify the treaty, the withdrawal will take place of the first day of the following month. Given that this would be an unexpected outcome, GBP implied volatility would rise sharply.

• 20th – 21st June – EU leaders will review Brexit progress at their next summit in June, but are already playing down the importance of the date.

• 29th September – 2nd October – Conservative party conference – it remains to be seen whether Theresa May will be still be leader of the Tory party come the end of September given the enormous pressure on her to resign. Either way, the party conference could mark the crowning of a new leader and a new approach to Brexit. If this new approach were to be led by a Brexiteer, sterling would almost certainly come under pressure amid renewed concerns of a hard Brexit.

17th – 18th October – Last EU summit before Brexit.

31st October – EU leaders have marked this date as the point at which the UK must choose whether to ratify the exit treaty, leave with no-deal or revoke Article 50.

As risk managers, we can’t ignore the possibility of a resolution to Brexit negotiations before the end of October although we believe it is unlikely. Implied volatilities (see chart below) in the options market suggest this is a common perception, but that gives us reason to be cautious since the potential impact is greater when the outcome is not expected. For most of our clients, short dated options rarely form part of their hedging portfolios, but this could be an opportune time for a buyout fund looks to hedge a short-dated entry or exit risk using options.

Chart – GBPUSD 1y ATM Implied Vol

Overall, we still feel that there is sufficient political momentum to favour a softer Brexit resulting in a relief rally for sterling. As such, we retain our overall bullish view from March, but postpone any dramatic rally in sterling until the fourth quarter of this year.

*our EURUSD and USDCAD forecasts remain unchanged (see pages 5&6 of this week’s Risk Insight for more details).

Author: Marc Cogliatti