Pound traders set Brexit bets as key summit comes into play

London - What will Brexit look like in three months’ time? Pound traders are trying to figure it out.

Wednesday marks three months until a key European leaders meeting that could shape the final divorce. That means benchmark three-month sterling volatility will start to cover the October 19 to October 20 summit for the first time. Traders need to gauge how a German election, three months of talks and political feuds in the UK will change the Brexit outlook by then.

With discussions resuming in Brussels this week, the EU’s chief negotiator Michel Barnier has said “sufficient progress” needs to be made on the terms of the separation before discussing a future trade relationship. It’s up to EU leaders to decide whether that progress has been made, as the clock ticks down to the March 2019 deadline for Britain’s exit.

“The market is leaning toward a firm no deal and a hard Brexit fallout scenario,” said Neil Jones, the head of hedge fund sales at Mizuho Bank in London, adding that a change of mood before the summit would benefit those going long on volatility. “The vol move could be quite violent on a soft Brexit.”

Three-month implied volatility, a measure of pound price swings based on options, has declined this year to about 7.86%, a far cry from the 18.56% reached on June 14 last year, days before the EU referendum. Given market positioning, Jones said that if the talks lead to a shift toward a smoother split or closer trading ties, it could shoot through 10 percent and trade at 15.

Options point to sterling weakness. The premium for contracts to sell the currency versus the dollar in three months, over the cost to buy, was at 0.61 percentage points. That has narrowed from 1.8 percentage points on January 17 when UK Prime Minister Theresa May announced plans to pull out of the EU’s single market in a speech. “On a soft Brexit I sense it will move back to flat, which is sizeable,” Jones said.

The market will also factor in risk events such as two Bank of England policy meets and Germany’s federal elections in September. Polls suggest Chancellor Angela Merkel will win a fourth term but the make-up of her coalition, and what stance it could take on Brexit, remains unclear.

May’s challenges

The UK’s inconclusive election in June has spurred talk of a more conciliatory approach by May. The UK acknowledged last week for the first time in writing that it will have to pay money to leave the EU, one of the thorniest issues in the talks.

May, meanwhile, will face her own set of domestic challenges that could swing the pound. After a summer recess ending September 5, Parliament will debate her bill to transpose all existing EU legislation into UK law.

When it was introduced to the House of Commons on July 13, it sparked a backlash from opposition parties including Labour and the Liberal Democrats, who said they would seek to amend it.

She’s likely to have even greater difficulties in the upper chamber, the House of Lords, where she doesn’t have a majority. As if that wasn’t enough, consent for the bill is required from the Scottish Parliament and Welsh Assembly.

The semi-autonomous Scottish and Welsh governments have already said they’d oppose it, with Scottish First Minister Nicola Sturgeon and her Welsh counterpart Carwyn Jones calling it a “naked power-grab.”

And to cap it all, prominent members of her own party have suggested her days are numbered, after she frittered away an overwhelming lead in the polls before the election and ended up losing seats.

To stay in power, the premier must navigate her Conservative Party’s annual conference which runs October 1 to October 4 in Manchester, when simmering resentments may come to a head, just two weeks before the EU summit.

“It could prove a significant event for the pound,” said Lee Hardman, a foreign-exchange strategist at MUFG in London. “It would be reasonable for the market to price in the higher event risk.”

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