As deadlines for the UK’s expected departure from the EU grow closer without final agreement on any of the remaining major issues, the uncertainty over what could happen is playing out in global currency markets by way of rising pound volatility.
Indeed, the shifting directions of the national currency have closely paralleled the fortunes of UK negotiators in their discussions with European counterparts. With the prospect of a messy Brexit currently on the rise, the pound has once again become the focus of volatility in currency markets.
Close followers of FX markets will have noticed that the past couple of months in particular have resembled sterling’s behaviour in the lead up to the UK referendum in 2016. As the outcome of that vote moves towards reality, the complexity of the process that began two years ago has started to occupy the minds of market participants around the world, especially as the idea of a ‘no-deal’ Brexit has started to look like a realistic possibility. We would put the current probability of this happening at 20%.
Hedging your bets
The uncertainty brought about by increasingly fraught political discussions between the EU and the UK is most challenging to owner-managers and finance directors who need to manage their treasury needs over the long term.
Those with international exposure will be particularly focused on developing ways to hedge against any severe currency fluctuations. In both cases, they need to decide whether to seek comprehensive currency cover for the next 12 months or leave their hedging requirements to the spot market.
Importers will also need to consider the consequences of a no-deal Brexit, the prospect of which has already created turmoil in the recent historic lows of sterling versus the US dollar.
It’s a conundrum that will be difficult to avoid in the coming months, but we believe there are strategies to deal with the most likely scenarios.
What price volatility?
Some of the potential for a Brexit shock is already priced into the options market. Options often behave as barometers for how the market views the likelihood of world and market events that create volatility. This includes responding to developments surrounding the conditions for the UK’s exit from the EU.
GBPUSD ‘at the money’ volatility has been steepening over the past three months, particularly in medium-term dates, with six-month volatility hitting close to 9% from below 8% at the end of May. This corresponds to the period when a decision would need to be made for implementing Brexit under Article 50 of the Lisbon Treaty.
When compared to previous risk events, such as the financial crisis and the Brexit referendum vote itself, the recent move has been modest, so it may be wise to treat it as a tremor before a potentially larger shakeup in financial markets. Options markets also provide indicators for when there is increased demand in the market to position for GBP strength versus GBP weakness.
So looking at the pricing, the market is waking up to the event risk of a messy exit.
So what can businesses with substantial currency exposures do to allow them to sleep easier at night? There are always internal factors that can be controlled, such as budget costs, currency forecasts and the general logistics of Brexit planning.
To address external factors, we work with clients to develop solutions that can guide them in a cost-effective way through any event risk, while maintaining flexibility to meet their foreign exchange and business requirements over the coming months.
Much of the Brexit-related risk for the pound is front-loaded, so we’re starting to see clients bring a percentage of their 2019 requirements into a vanilla option.
Many of our corporate clients are making use of three and six-month vanilla options to shelter their businesses from the collateral damage of a breakdown in negotiations. In the event of a collapse in sterling, these options act as a kind of proxy insurance policy.
Vanilla options also provide flexibility by allowing for the Brexit ground to settle and empowering holders to make more informed decisions once a clearer picture of the UK’s departure from the EU is established.
For example, a GBPUSD vanilla option to sell £500k and buy USD at 1.2500 currently costs 0.75% of the notional (£3,750). By owning this option a client is able to protect their business from a Brexit disaster scenario of no-deal or a messy exit.
It does this while also maintaining flexibility to participate in GBP strength if the UK does manage to achieve a clean and acceptable exit.
Many clients who expect to purchase a total of £10m worth of USD in 2019 are using options to the tune of 50% to expire between November and January. Then with a view to rolling these out to the rest of 2019 once a clearer picture of Britain’s departure emerges.
Such a flexible approach requires the expertise and resource of banking partners who understand your business and objectives. This is, and will be vital to navigating your business through choppy markets and potential political instability.
Heightened market anxiety surrounding Brexit is likely to continue for some time while events swirl and politicians dither. But it is comforting to know there are proactive steps to mitigate currency risk that can work for your business.
Reasons why Brexit impacts currency and remains high on the boardroom’s agenda
- Mixed signals from the UK government
Disagreements over the UK’s Brexit proposal (known as the Brexit White paper) have come to the fore.
- Unrest within the ruling party
The government’s job of presenting a unified front to Brussels in Brexit negotiations has become an increasingly tough challenge against a background of unrest within the Conservative Party.
- There’s the increasing possibility of a no-deal outcome
With little progress in talks with Brussels, further effort is being put towards ‘no-deal’ Brexit preparations. This has left sterling reeling.
- A deadline is approaching
Hopes of an agreement being reached in time for an 18 October EU Summit have evaporated. A special summit in November and a scheduled December summit are now the more likely points for crunch talks.
- Any deal will have to go back to the UK Parliament
Some ratification of any Brexit deal proposed within EU Parliaments would follow while the UK Parliament would also hold a ‘meaningful vote’. As things stand, the UK is set to Brexit on March 29, 2019, with or without a final Brexit package. With the clock ticking, UK-focused investors are getting nervous.
About the author
Jonathan Pryor is head of FX at Investec.