Pound traders eye Brexit talks to shock it out of euro doldrums

19/06/2017 02:11 AST

The formal start of Brexit negotiations on Monday may prove more of a catalyst for the pound than an inconclusive general election, a surprise hawkish shift by Bank of England officials and a spate of disappointing economic data.

Despite the raft of surprises to hit sterling this month, it’s set to record its tightest monthly range versus the euro since 2014. That may change as, almost one year since Britain voted to leave the European Union, UK Brexit secretary David Davis and his European counterpart Michel Barnier open negotiations.

The two sides will hammer out how talks will be structured, whether there would be a transitional phase to help businesses to re-adjust to new rules and what the divorce would mean for rights of EU citizens living in the UK and Britons living on the continent. In all of this, it’s the “tone” that interests Richard Falkenhall, senior strategist at SEB AB in Stockholm. He’s particularly keen to see how the two sides settle the contentious issue of the Brexit bill.

“The tone of the negotiations, whether they turn out to be constructive or the other way around, that may be very, very important,” SEB’s Falkenhall said. “One of the things they will start to discuss now is how much the UK will have to pay to the EU, that will be very crucial. If they reach a solution or get closer to each other on this, then I think it’s a very, very positive sign.”

Tumultuous time

The pound’s relative resilience to an otherwise tumultuous time in British history is in contrast with its swings in 2016. That year saw its biggest daily drop on record in the aftermath of the UK’s shock vote to quit the EU and a mysterious flash crash in October.

Sterling has traded in a range of 2.141 pence against the euro this month, the lowest since August 2014. The pound was at 87.52 pence per euro as of 3:40 pm in London on Friday. “The actual outcome of the negotiations is still quite difficult to predict,” analysts at Credit Agricole CIB, led Valentin Marinov, head of Group-of-10 foreign-exchange strategy, wrote in a client note on Friday. They said their “long-term valuation model still suggests that the best hedge against a potential hard or disorderly Brexit may be long EUR/GBP,” while the near-term outlook for sterling remains “extremely challenging.”

Measures of implied price swings in the pound against the euro over the next one and three months are close to the lowest levels since 2015. While this is in part due to the global decline in volatility, it could change should sterling closely follow negotiation headlines. The currency’s volatility should be “much higher than what we have right now and people are a bit too complacent,” SEB’s Falkenhall said. He sees the pound weaken to around 91 pence per euro, a level not seen since October, if talks turn “unfriendly” and the “hard Brexit risk premium continues to increase.”

Options traders are more bearish on the pound than any other Group-of-10 currency over the next three months, according to risk-reversal data. The case for turning positive on the pound still eludes most market participants. Robeco Investment Solutions’ portfolio manager Jeroen Blokland said he has initiated a long position in the euro against sterling as “there is a chance Brexit could turn ugly.”

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