Negotiators will meet once more in early June 2020 to decide if it’s worth continuing the discussions. The UK government’s EU Exit Operations (XO) committee — also commonly known as the “no-deal planning unit” is meeting more regularly. The UK government denies that it will extend UK membership in the Common Market beyond December 31, 2020, however, it is possible the economic damage from the pandemic could nudge them to seek some sort of delay, particularly if no acceptable deal is in place.
Going into this next round of negotiations, GBP options markets are more skewed to the downside than usual with out-of-the-money (OTM) put options substantially more expensive than usual compared to OTM calls. By May 19, the options skew (also called risk reversal) was more negative than it had been 92% of the time during the previous two years. Options traders have, at times, proved prescient with respect to future moves in the pound: options skew was extremely negative in the lead up to the 2016 referendum and, indeed, GBP collapsed after the result became apparent (Figure 2). Skewness isn’t as negative this time, but pound options are considerably more expensive than those on EUR when seen from a USD perspective (Figure 3). Moreover, most of the recent spikes in both implied volatility and risk reversal have been motivated by concerns over the progress of Brexit negotiations. The one exception occurred during an incipient dollar-funding crisis in mid-March. After the US Federal Reserve stepped in, that issued was resolved quickly.
UK interest rate markets have shown less reaction to Brexit-related events than the currency market. The Bank of England (BoE) is focused on containing the economic damage from the pandemic and interest rate traders are debating whether the BOE will follow the European Central Bank and the Swiss National Bank down the path to negative interest rates (Figure 4). If the BoE does go negative, it might have unexpected consequences for exchange rates. Of the four central banks which went to negative rates during the past decade, two of them quickly saw their currencies strengthen. The other two had more mixed results, yet were still consistent with the concept that negative rates do not work as intended. Sweden has already exited negative-rate territory. Coming soon, our report on “What FX Markets Say About Negative Rates.
Normally a stronger currency is a sign of a relatively tighter monetary policy. While negative rates are meant to loosen monetary policy and support economic recovery, they instead can act as a tax on the banking system and may interfere with the process of credit creation. An inadvertent and undesired tightening of monetary policy that stems from negative rates may explain, in part, why currencies subject to negative deposit rates have tended to strengthen rather than weaken as is commonly the case when central banks ease monetary policy.
While its uncertain if the BoE will decide to push rates below zero, if the central bank were to pursue negative rates, it might strengthen the pound. A stronger currency could, in turn, slow the recovery from both the pandemic as well as making it more difficult to absorb any additional shocks from a possible no-deal Brexit.
Finally, when it comes to the pandemic, other than obliging the BoE to quickly return to near-zero rates and implying a vast expansion of the UK’s budget deficit, the pandemic appears to have had a limited impact upon the pound beyond the transitory dollar-funding issues in mid-March. For the moment, the UK’s economic and fiscal situation in the face of the pandemic very much resembles that of its neighbors across the Channel and across the Atlantic.
One question for the pound post-Brexit is whether it will begin to trade more like the Australian (AUD) or Canadian dollar (CAD)? We think that this is unlikely. Even post-Brexit, GBP could probably remain in EUR’s orbit for a number of reasons, not least of all because over 40% of Britain’s exports go to the European Union. Even if that number drops a bit under a no-deal Brexit scenario, UK’s trade with Europe is likely to far exceed its trade with any other country. Secondly, the UK ceased to be a net exporter of oil over a decade ago and with North Sea reserves dwindling and the UK having no other substantial domestic commodity production, there is little reason to think that GBP will begin to trade like AUD, CAD or other resource-dependent currencies.
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By: CME Group