ETF Securities Research Blog

Nothing to worry about for GBP after election…

Although markets are pricing significant risk of a GBP decline over the coming week, traders appear unconcerned about the outlook for the UK and GBP in the longer-term.

Current options pricing indicates that the GBP is the by far least preferred currency against the US Dollar in coming weeks. In fact, GBP pricing suggests that the market is priced for a potential UK breakup, with traders equating the current situation to the period ahead of the Scottish referendum.

rr1wk

However, taking a longer-term perspective highlights a more pragmatic outlook by traders. Looking ahead six months in the future, traders are less concerned, with GBP taking 3rd least preferred currency against the US Dollar, ahead of both the New Zealand and Australian Dollars.

Indeed, this is further borne out by looking at the differential between the 1-week and 3-month GBP currency options volatility: the difference shows that near-term pricing compared to longer-term pricing is more extreme than at the time of the Scottish referendum.

rr1wk-3mth

Such pricing indicates that:

  1. Investors are concerned about the near term implications of a potential downside move for GBP and this is reflected in the price of hedging that downside risk; and
  2. The market expects a Conservative victory (although the strength of such conviction remains the big question mark); and
  3. Although there is likely to be some volatility in coming days, the underlying economic backdrop for the UK and in turn GBP remains resilient. Additionally, that options pricing returns to normal quickly after a specified event.

Our base case remains that following the UK election, as FX volatility continues to moderate, GBP could again test the 1.30 level. We expect a potential break to the upside as the domestic economy remains resilient, prompting a more hawkish monetary policy stance, with GBP targeting 1.35.