Beware, Pound to Become More Volatile Against the Euro say Strategists

After a period of relative calm, the GBP/EUR exchange rate could be entering stormy seas once more.

Currency strategists are ramping up bets that the Pound-to-Euro exchange rate will suffer a rough ride over coming months as the Brexit talks move onto their most crucial phase and the clock on the article 50 timer ticks away.

It's been a good start to the year for Sterling - the currency has risen against most of its peers - with a 1.5% gain being eked out against the Euro. Itself one of the better performing global currencies.

The gains against the Euro have been relatively mild however, by historical standards, with trading being confined to a range between 1.11 and 1.15 over recent months as volatility settles down.

However, there are growing signs that foreign exchange volatility - as a whole - is starting to pick up again, lead by the sharp decline in the US Dollar over recent days.

"Recent exchange rate moves have dominated the soundbites from the World Economic Forum in Davos as our index of implied global FX volatility hits the highest level since October," says Hans Redeker, an analyst with Morgan Stanley.

Volatility to Spread

With currency profressionals eyeing choppy waters ahead, strategists at investment banks Société Générale and J.P. Morgan have both advocated betting on increased volatility in the Pound-to-Euro exchange rate over recent days, citing the plethora of risks facing the British currency during the year ahead.

“EUR/GBP volatlity is at the bottom of the range. Interestingly, the GBP/USD is at the top, suggesting that some Pound risk may not yet have reached the EUR/GBP cross,” says Olivier Korber, a derivatives strategist at Société Générale.

The call comes as the volatile trading conditions that buffeted the Pound ever since the EU referendum of June 2016 have calmed dramatically, making for a more benign currency in terms of risk. But, this could soon change.

“Three month realised volatility has hit the bottom within the regime in place since the start of 2015, strongly suggesting a volatility bounce from there. Most of the Sterling appreciation happened on the back of solid price dynamics, which triggered the first BoE hike at the end of last year. But market forces should eventually revive our bearish bias,” says Korber.

The January move has been brought about by a much larger rise in the Pound-to-Dollar rate, which is up 5.76% in January, than has been seen in the Euro-to-Dollar rate. EUR/USD has risen by 4.19% to trade above 1.2500 Thursday.

Brexit Uncertainty to Stoke Wider Moves

Korber and his colleagues at Société Générale say the EU's timeline for Brexit trade talks leaves hardly any time for even a skeleton of the future trading relationship to be sketched out, "making one despair about what kind of deal will finally be struck.“

“Uncertainty surrounding trade with the EU will resurface. Further Sterling turbulence is likely, prompting us to expect higher volatility,” the analyst writes, in a recent note.

Betting on a spike in volatility doesn’t necessarily say anything about the broader direction a currency pair is likely to take, just that price swings could soon become more wild.

“We are heavily underwater on a 1Y EUR/GBP volatility swap but hold this as we regard the recent slide in volatility as a one time re-pricing to agreement on a Brexit transition,” writes Paul Meggyesi, vice president of global currencies and commodities at JP Morgan.

J.P. Morgan recently gave up making directional calls on the Pound-to-Euro exchange rate, after being burned by bearish bets that didn’t to plan late last year, but is still betting on an increase in volatility during the months head.

“The more important issue - the nature of the UK’s new trade arrangement with the EU – remains to be determined, and as such there is scope for fresh instability around the Brexit process this year, even if the process looks relatively free of drama for the next few months,” says the analyst.   

In addition to both banks betting on a rough ride for Sterling, Societe Generale still has a bearish outlook on the Pound-to-Euro rate and is forecasting an eventual return to lower levels over the coming quarters.

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