Pound-to-Euro will be Volatile in Year Ahead say J.P. Morgan but Directional Calls Best Avoided For Now

 

The UK has the wrong split of growth and too much inflation. Brexit risks are also a threat to Sterling but directional calls are best avoided for the time being.

JPMorgan has walked away from a bet against the Pound-to-Euro rate after the British currency received a boost in November from anticipations of progress in the Brexit negotiations, which saw derivatives that the bank's strategists were holding become worthless at their expiry date.

The bank’s team had been using FX options to bet on a rise in the EUR/GBP rate, or a fall in Pound-to-Euro, which would have paid out if the EUR/GBP price was above the 0.9150 level at the time of expiry.

“We bought a call spread in order to fade the optimism inspired by the BoE’s policy pivot in the autumn,” say Paul Meggyesi, head of global FX strategy at JPMorgan, and Meera Chandan.

JPMorgan’s team had been holding the bet since late September, just after the Bank of England first signalled it would raise interest rates, out of an expectation an actual rate rise would lead to weakness in the currency.

“In our view the UK has the wrong split of nominal GDP growth to support a stable hiking cycle and a sustained uptrend in GBP – the same nominal GDP as the Euro area but with twice as much inflation and less than half as much real growth,” the pair add, in a recent note.

For the most part, they were right. The Pound-to-Euro rate weakened notably from the end of September as optimism over the prospect of a rate hike diminished.

However, come the middle of November, the Pound was back on the front foot as markets bet a deal to move Brexit negotiations along to phase 2 was near. This left the derivatives its strategists were holding worthless at the time of their expiry in December.

“The macro data since the hike has been nothing to celebrate yet GBP has remained be supported by the Brexit process which was just about kept on course after nearly faltering over the Irish border issue and which has now shifted to the discussion to the future trade arrangements,” the pair add.

European negotiators said last week that “sufficient progress” had been made on the subjects of the “divorce bill”, citizens rights and the Northern Irish border, so European negotiators would be able to discuss the subjects of trade and transition in the New Year.

“There will be many future twists and turns in the process and we are not convinced that hard Brexiteers in the UK cabinet are prepared to compromise on the principles of trade as they have the tactics of withdrawal,” Meggyesi and Chandan write in a recent strategy briefing.

The strategists have flagged a possible exit by the UK from the European Union’s single market and customs union as something that will be damaging to the economy, lowering potential growth in future years and placing downward pressure on the Pound.

This is next pivotal question for Prime Minister Theresa May and her team of negotiators. Whether to subject themselves to the political firestorm that would surely come from pursuing continued single market membership or to instead, push for a clean break with the EU.

“For now though we stay directionally neutral and prefer to express the economic and political uncertainties in the UK through a long vol position in EUR/GBP instead,” say Meggyesi and Chandan.

The Euro-to-Pound rate was quoted at 0.8813 during early trading Tuesday, up slightly from recent lows, which puts the Pound-to-Euro rate at 1.1344.

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