FX: Sterling risk premium tracker
With Brexit uncertainty rising, we introduce a sterling risk premium tracker. We look at various measures of sterling stress, gauged by factors such as our short-term financial fair value model, speculative positioning & the options market. We think the risk of no-deal Brexit / early election is underpriced by the market and look for more downside to GBP
Where we are now?
Despite the rebound in the UK pound in the last few weeks, the short term sterling risk premium isn't extreme.
We estimate it to be worth around 2.5 % in EUR/GBP (vs 5% this August), with EUR/GBP still within its 1.5 standard deviation band as can be seen in figure 1. This means that more risk premium can be built into sterling. Our financial fair value model is based on short-term drivers of currencies such as rate spreads, yield curves and a gauge for risk appetite.
Figure 1: More scope for GBP risk premium to rise
The build-up of speculative GBP/USD shorts paused in recent weeks. Although elevated, they are still below the 2017 extremes (33% of open interest currently vs 43% back then – as can be seen in figure 2). In the case of the rising probability of a no-deal Brexit and/or early elections, the shorts can rise further.
Figure 2: Speculative positioning elevated but below the 2017 levels
The options market clearly shows signs of stress. The EUR/GBP implied volatility curve (the term structure) is kinked around the deadline data as can be seen in figure 3 and GBP volatility premium is the highest in the G10 FX space (figure 4). Still, EUR/GBP risk reversals can rise further (figure 5)
Figure 3: The GBP volatility curve already heavily kinked around the Brexit date
Figure 4: Sterling volatility risk premium remains high
Figure 5: Risk reversals already at stressed levels but can get stressed even more
The recent decline of the pound over the last few days has turned sterling into the G10 FX underperformer yet again (figure 6) but we don’t expect the Bank of England to provide any help to the struggling pound, with dovish market pricing to firmly remain in place (figure 7). Currently, more than one full 25bp rate cut is priced in within six months.
Figure 6: GBP turning into a G10 FX underperformer yet again
Figure 7: Market pricing Bank of England rate cuts
What to look for?
If parliament moves a step closer to legislating against no-deal Brexit today by seizing control of the parliamentary agenda and prime minister Boris Johnson subsequently and successfully calls for early elections (likely in mid-October), we would see this as GBP negative given that (a) the Conservative party under PM Johnson's leadership will likely run on the ticket of a divisive stance vs EU (“no ifs or buts”), (b) the alternative option of a Labour government under Jeremy Corbyn may not be seen as an overly positive for market participants.
As we've written before, we view early elections as negative for GBP and continue to see downside risks to sterling. This is consistent with our forecast of EUR/GBP 0.95 within 1-3 months and GBP/USD falling to 1.17.
Download
Download article
3 September 2019
What’s happening in Australia and around the world? This bundle contains 7 articles"THINK Outside" is a collection of specially commissioned content from third-party sources, such as economic think-tanks and academic institutions, that ING deems reliable and from non-research departments within ING. ING Bank N.V. ("ING") uses these sources to expand the range of opinions you can find on the THINK website. Some of these sources are not the property of or managed by ING, and therefore ING cannot always guarantee the correctness, completeness, actuality and quality of such sources, nor the availability at any given time of the data and information provided, and ING cannot accept any liability in this respect, insofar as this is permissible pursuant to the applicable laws and regulations.
This publication does not necessarily reflect the ING house view. This publication has been prepared solely for information purposes without regard to any particular user's investment objectives, financial situation, or means. The information in the publication is not an investment recommendation and it is not investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. Reasonable care has been taken to ensure that this publication is not untrue or misleading when published, but ING does not represent that it is accurate or complete. ING does not accept any liability for any direct, indirect or consequential loss arising from any use of this publication. Unless otherwise stated, any views, forecasts, or estimates are solely those of the author(s), as of the date of the publication and are subject to change without notice.
The distribution of this publication may be restricted by law or regulation in different jurisdictions and persons into whose possession this publication comes should inform themselves about, and observe, such restrictions.
Copyright and database rights protection exists in this report and it may not be reproduced, distributed or published by any person for any purpose without the prior express consent of ING. All rights are reserved.
ING Bank N.V. is authorised by the Dutch Central Bank and supervised by the European Central Bank (ECB), the Dutch Central Bank (DNB) and the Dutch Authority for the Financial Markets (AFM). ING Bank N.V. is incorporated in the Netherlands (Trade Register no. 33031431 Amsterdam).