The Pound is Becoming More Stable as Implied Volatility Hits Fresh Lows

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Trader exchange rates

Above: Traders looking to bet on volatility in Sterling exchange rates could be disappointed as the currency is expected to settle down after a rough two years.

Data suggests those with foreign currency exposure are not expecting Pound Sterling to be as volatile in 2018 as it was in 2016 and 2017.

Volatility will probably only become a threat for Sterling in the latter part of 2018 meaning businesses and individuals with currency exposure are likely to enjoy a benign first half to the year.

Three month implied volatilities in GBP/USD and GBP/EUR Options are close to current market prices for the underlying exchange rate, which suggests that traders are content to hold Sterling for the foreseeable future without protection against wild price swings.

Buying protection against Sterling volatility has been popular since 2016 when the potential threat to the Pound posed by the E.U. membership referendum was first identified. The vote to leave sparked a notable decline in value in Sterling which has since recovered. Yet, for the duration of 2017 volatility in the Pound was still notable as markets expressed nerves over the prospect of the U.K. and E.U. reaching a deal.

Options are financial contracts that enable companies and individuals to protect themselves against swings in prices of almost any underlying instrument, readers can learn more about how they work here.

In short, those with currency exposure are not expecting the Pound to embark on a wild ride in the foreseeable future, and this largely rests with the view that the upcoming negotiations on Brexit are unlikely to deliver fireworks until the relevant deadlines come into view.

“Brexit is likely to increasingly become an issue again over the coming days. But in the end the scramble about the start of the second phase of the Brexit negotiations confirmed that the talks will only see a breakthrough when a deadline is approaching and ultimatums are presented,” says Esther Reichelt, an analyst at Commerzbank.

“The next deadline that is currently under discussion is only in October when it is hoped that the parties will have come to an agreement regarding a trade agreement. As little is likely to move on the Brexit front for now, and a further Bank of England rate hike is unlikely to be an issue over the coming months due to the rather weak economic outlook, GBP exchange rates are largely determined by external factors,” adds Reichelt.

Indeed, at the start of the new year Sterling has been subject to benign trading conditions, with the Pound-to-Dollar exchange rate seen at 1.3525 and the Pound-to-Euro exchange rate at 1.1326 Wednesday. Both exchange rates are more a function of US Dollar strength and Euro weakness as opposed to any Sterling-specific drivers.

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Traders are Less Pessimistic on the Pound

The data on volatility is constructive for those hoping for a stronger or more stable Pound, as risk tends to fade when markets stabilise, but its not just in volatility markets that Sterling is seeing a more constructive outlook developing.   

Data on trader positioning from major financial institutions reveals sentiment towards the British Pound continues to improve which, at best, suggests the potential for further gains over coming weeks and months. At worst, it suggests the prospect of a significantly weaker Sterling is diminishing in the eyes of traders.

How the global foreign exchange markets are positioning is indicative of which way a currency is likely to move: traders being 'long' on a currency suggests they believe it will rise.

When they are 'short' they are betting it will fall. It will come as no surprise to readers that since the Brexit referendum of June 2016, sentiment towards Sterling has fallen in the 'short' category.

This sentiment has corresponded with double-digit declines in the value of Sterling, which saw the Pound-to-Dollar exchange rate fall into the 1.20's region and the Pound-to-Euro exchange rate fall into the 1.08's.

However, data on trader sentiment now appears to be turning in such a way that would suggest the recent recovery in Sterling could yield further gains.

Analysts at global investment banking giant Morgan Stanley say their in-house models show GBP positioning increased to 'long' in the final weeks of December.

"There was broad-based GBP buying across all investors captured in our positioning tracker. GBP was one of the only two currencies bought by non-commercial IMM accounts in the three weeks to December 26," says  Strategist Gek Teng Khoo at Morgan Stanley in London.

Khoo say this trend was led by asset managers buying to become mostly 'long' on the British Pound for the first time since June 2016, while leveraged funds were small sellers.

"GBP was also the only currency bought by Japanese retail accounts in the last three weeks of December, and the only currency where sentiment is bullish. Global macro funds were also GBP buyers. While bullish sentiment has not reached extreme levels yet, long positioning could be a risk if sentiment turns around," says Khoo.

The data is revealed by Morgan Stanley's FX Position Tracker which monitors sentiment amongst traders in the global currency trading community.

It combines a host of available data points on sentiment amongst traders in the global currency sphere; including the IMM Commitment of Traders Report, the Toshin, TFX and internal measures of ETF flows and internal sentiment monitors.

So with improved sentiment, all those wishing for a stronger Pound need now is for U.K. economic data to hold up or improve and the Bank of England to deliver further interest rate rises.

And of course, the entire house of cards rests with Brexit and the ability of politicians on both sides of the English channel to see sense. Progress here will allow the trading community to smile on the Pound a little more.

"These exchange rate levels are consistent with an improved perception of the risk posed by Brexit, although Sterling could weaken further on both potential disappointments from the British economy, and lingering uncertainty in any case on the terms of the future trade agreement with the E.U.," says Asmara Jamaleh, an Economist with Intessa Sanpaolo.

Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here.

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