Sterling volatility crowns Brexit unknowns

Summary

Sterling volatility is one sure thing whilst Brexit uncertainty reigns.

Sterling sellers take back control

That sterling has scaled a 3.8% advance and seen a 2.7% slide within a fortnight illustrates the slippery hold traders have of chances that Britain could avoid crashing out of the EU in 137 days. The latest Downing Street upset—yet another ministerial resignation on Friday—underscored the market mood yet did not create it. Note the pound traded against the dollar had already begun reversing a near-4% six-day ramp in the middle of last week. Hence, even with critical UK economic data out on Tuesday and Wednesday—UK employment and inflation data, respectively—Brexit will remain the preeminent influence. In the absence of clarity, that suggests the bias for the pound is almost inevitably lower from here. Any bounce on promising economic news is likely to meet renewed selling.

Downing St in defence mode

Predicting when key unknowns could be clarified is an appropriately murky exercise in itself. With Downing St in defence mode after last Friday’s departure, we've got to assume the chances of agreement on the current formula are lower, though we may not know for some time, if ever. A new three-pronged approach to avoid a hard border between Ireland and Northern Ireland (NI), the key unresolved part of a Brexit treaty, looked initially set to be discussed by Theresa May’s cabinet on Monday. The package reportedly comprises (I) an agreement to replace the NI backstop, (II) an extension of the UK’s transition period under EU rules, and (III) a new fall back “backstop”, including a UK-wide customs union. But Number 10 will be aware that if it inches much further to accepting conditions that other cabinet members find anathema, it risks seeing the upset escalate to a full-blown crisis. The DUP, the Northern Irish party that props up Theresa May’s government, called the outline a “betrayal”, adding further grounds for Downing Street to turn cautious. The PM’s office eventually denied that a cabinet meeting on Monday to approve the deal was ever scheduled.

Cable’s short-lived ‘Barnier bid’

Sterling did see some relief from its slump of as much as 133 pips on Monday, after the FT reported that the EU’s chief negotiator, Michel Barnier told EU ministers "the parameters of a possible agreement are very largely defined". The report also backed the notion that substantial cabinet discussions on the new package could begin on Tuesday, following its publication. Theresa May’s spokesman later expressed scepticism about the report. With even less certainty that an emergency EU summit pencilled in for some time between 18^th and 21^st November will take place now, markets are unlikely to position strongly for confirmation of an agreement between the UK and EU, much less one that wins cabinet backing. Indeed, one-week sterling implied volatility, the rate at which options project the pound will move over the length of the trade, has spiked on Monday. The most ‘vanilla’ one-month option also shows that volatility has now surpassed prior highs for the year in February that accompanied broader market turmoil. Under these conditions, the risk that sterling could revisit lows for the year around $1.26 marked in August, having narrowly avoided doing so last month, is rising.