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Pound Sterling to Fall to Parity vs. Euro if Johnson Follows through with Brexit Threat says one Analyst, but Options Markets are Incredibly Relaxed on Prospect of 'No Deal' Brexit

Brexit and the outlook for Sterling vs. Euro

Image © Mark Ramsay, accessed Flickr, reproduced under CC licensing conditions.

- Potential for 1 GBP to buy 1 EUR for "first time" - Howard

- Julius Baer see chance of near-term rebound in the Pound

- Investors not as nervous of Oct. 31 Brexit deadline as when approaching previous deadlines

The British Pound could well succumb to its lowest-ever levels against the Euro before 2019 is out warns a leading foreign exchange analyst we follow, however analysis of the foreign exchange futures market suggests investors are not yet overly concerned that a 'no deal' Brexit will take place in 2019.

"The probability of EUR/GBP rising to 1.00 for the first time will grow if Boris Johnson maintains his hardline Brexit stance," says Robert Howard, a currency analyst with Thomson Reuters.

Unless Johnson's campaign suffers a catastrophic failure, Johnson should be in 10 Downing Street by July 23.

Johnson has said in a number of interviews this week the UK would leave the European Union "do or die" by the official October 31 deadline,

Howard says this stance on Brexit helped push the Pound-to-Euro exchange rate lower to threaten 1.1143, last week's 22-week low, on Wednesday.

The exchange rate is quoted at 1.1167 on Thursday, June 27.

The suggestion that the Pound could fall to parity with the Euro is in part based on expectations that foreign investors will pull large sums of invested capital out of the UK in the event of a 'no deal', putting downward pressure on the exchange rate.

Howard cites the Bank of England's Anil Kashyap, who last week observed that Britain increasingly relied on "flighty" foreign funding that could be withdrawn at short notice ..., "and the risk of capital flight from the UK could grow if the chance of a Halloween 'no deal' Brexit continues and Johnson beats Jeremy Hunt in the race for the Tory crown," says Howard.

The UK relies on foreign funding because it runs a sizeable current account deficit, meaning it spends more on imports than it earns from exports. The ONS reported earlier this month the total trade deficit (goods and services) widened £2.7 billion to £15.6 billion in the three months to April 2019, as the trade in goods deficit widened £2.8 billion to £43.4 billion.

UK trade deficit

To keep the exchange rate steady the UK thus relies on inflows of foreign investor capital to counter the deficit in the trade of goods and services.

The UK has long been a darling for international investors who have snapped up property, companies, shares, bonds and a host of other investments. The concern is that were a 'no deal' Brexit to diminish the attractiveness of these investments, capital could head the other way and force down the exchange rate.

Bookmakers Paddy Power currently quotes 13/5 (an implied probability of 28%) that the GBP/EUR exchange rate will trade at 1.00 before year-end.

1.0635 marks the GBP/EUR low since the UK voted to leave the EU in 2016 while the all-time low is 1.0199.

However, we are hearing from technical analysts at Swiss bank Julius Baer that the Euro is now looking overstretched against the Pound near-term, and that the GBP/EUR exchange rate could bounce back.

Julius Baer note the Pound is trading in the lower portion of a long-term range versus the British Pound and that if the range is to be respected the Pound will snap back higher.

A major support area is located between 1.1136 and 1.1025, "as a result, the current risk / reward for going short EUR/GBP is increasingly attractive," says Julius Baer. Going 'short' on EUR/GBP is trader speak for selling the Euro and buying the Pound.

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FX Options Markets not Taking Seriously Chance of a ‘No-Deal’ Brexit in October: ING

While Robert Thomson at Thomson Reuters flags up the prospect of the Pound-Euro exchange rate falling to parity, at present the broader foreign exchange market appears to be more relaxed on such an outcome occuring.

Financial market pricing is not yet showing major concerns that the UK will leave the EU without a deal on October 31, despite Johnson saying the UK would be leaving “come what may”.

The options market - the buying and selling of currency contracts at a future date - are not yet showing huge demand to protect against volatility around the next Brexit deadline. What we have seen in the past that it became incredibly expensive to buy futures contracts around previous Brexit dates as investors bought protection against substantial moves.

In short, expectations for massive volatility were incredibly elevated.

“While GBP spot has softened across the board, the option markets remain quite reluctant to price in a no-deal outcome,” says Chirs Turner, head of global FX strategy at ING Bank.

The FX options market is the deepest, largest and most liquid market for options of any kind, with a notional value of $158bn in 2005, according to the Bank of International Settlements (BIS).

FX options are a cheap method of hedging currency exposure especially when there is a major risk event on the horizon. The UK leaving the EU without a deal on October 31 and the consequent negative impact on Sterling is an example of such an event, and normally options traders would be queueing up to purchase options to sell the Pound, known as ‘put options’ before the event so that they would benefit from downside, if it transpired.

Curiously, this does not appear to be happening according to option premiums which tend to rise as demand grows.

This suggests traders are not taking the chances of the UK leaving the EU without a deal seriously enough to hedge against it.

ING says the ‘volatility curve’ which uses option market data to forecast volatility in the Pound is not registering an expected spike at the end of October.

“The 4m-5m segment of the volatility curve – which captures the October deadline - shows no particular spike and the average implied volatility across the curve is considerably lower when compared to late 2018,” says ING’s Turner.

Although Johnson has pledged to leave the EU in October whether or not a deal is agreed, he has also said that he sees the chance of a cliff-edge Brexit as improbable.

During an interview on Tuesday, Johnson said that he thought a no-deal Brexit was "not where I want us to end up, it's not where I believe for a moment we will end up."

It is possible options markets agree.

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