FX: Sterling risk premium tracker

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.

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.

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)

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.