Surprise Surge in Pound Sterling Needs to be Hedged Against say Soc Gen, Eyeing Potential for Second E.U. Referendum

• Interbank quotes:
• Pound-to-Euro exchange rate today: 1 GBP = 1.1239 EUR
• Pound-to-Dollar exchange rate today: 1 GBP = 1.3764 USD

Above: Nigel Farage fires up the debate on the prospect of a second EU referendum. Image © Gage Skidmore

The British Pound could surge on an unexpected shift in Bank of England tone and an increased liklihood of a second referendum on EU membership being announced.

The strategy team at Europe's sixth largest bank - Société Générale - are recommending that clients consider protecting against unforeseen strength in Pound Sterling in 2018.

The call comes at a time most analysts do see Sterling continuing to pick itself up after the infamous slump of 2016 but are still unwilling to advocate a year of blow-out strength for the UK currency which remains beset by uncertainties relating to Brexit.

Nevertheless, surprises are the mainstay of the global foreign exchange market and should such a pro-GBP surprise materialise there is a good chance corporates and individuals with sizeable Pound-related purchases could lose out, particularly exporters who tend to benefit from a weaker Pound.

Hedging against such an outcome - by betting on the Pound - could mitigate some risks posed by a stronger Pound.

“Our base case sees GBP/USD meandering in a 1.30-1.40 range in 2018, with EUR/GBP following EUR/USD higher through 0.95. Considerable bad news is already priced in, and Sterling is already ‘cheap’ on most valuation metrics,” notes Olivier Korber, a strategist at Société Générale's Paris office.

However, analysts see the prospect of the Pound surging if a second Brexit referendum were announced later this year, or the Bank of England was to begin flirting with the idea of raising interest rates sooner rather than later.

The prospect of a second referendum has suddenly grabbed the attention of the political commentariat after Nigel Farage - ex-UKIP leader and perhaps the most influential politician of his generation (if you consider his role in Brexit) - suggested a second referendum on EU membership was in fact a good idea.

The idea has since been further advanced by comments from Donald Tusk, President of the European Council, who says on January 16 that were the British to change their mind they would be welcomed.

Unless there is a change of heart among our British friends, #Brexit will become a reality – with all its negative consequences - March next year. We, here on the continent, haven’t had a change of heart. Our hearts are still open for you.

— Donald Tusk (@eucopresident) January 16, 2018

The Bank of England moving towards further interest rates is however the most likely pro-Sterling surprise 2018 will offer we believe as an environment of persistently high inflation is all that is needed to drive such an outcome. Indeed, the UK economy remains robust, pay packets are increasing and global fuel prices are rising, therefore the Bank could well act on rates again in 2018.

Such developments, would see the Pound recover much of its post-referendum loss against the Dollar.

“The 1.40 level is the Brexit vote threshold in cable, strongly suggesting fast gains if it were to break higher,” notes Korber.

And be in do doubt; a stronger GBP/USD will feed into other Sterling-based pairs. We would therefore expect the Pound-to-Euro exchange rate to enjoy a notable bout of strength.

“A GBP/USD fall to the 1.20 low would require, above all else, a stronger Dollar rather than a weaker Sterling alone. We think the chances of a fall that far are about 5%, whereas we see the probability of GBP/USD appreciating through 1.40 at around 15%,” says Korber.

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Meanwhile, data suggests those with foreign currency exposure are not expecting Pound Sterling to be as volatile in 2018 as it was in 2016 and 2017 as they reduce their hedging activities on Sterling.

Volatility will probably only become a threat for Sterling in the latter part of 2018 meaning businesses and individuals with currency exposure are likely to enjoy a benign first half to the year.

Three month implied volatilities in GBP/USD and GBP/EUR Options are close to current market prices for the underlying exchange rate, which suggests that traders are content to hold Sterling for the foreseeable future without protection against wild price swings.

Buying protection against Sterling volatility has been popular since 2016 when the potential threat to the Pound posed by the E.U. membership referendum was first identified. The vote to leave sparked a notable decline in value in Sterling which has since recovered. Yet, for the duration of 2017 volatility in the Pound was still notable as markets expressed nerves over the prospect of the U.K. and E.U. reaching a deal.

Options are financial contracts that enable companies and individuals to protect themselves against swings in prices of almost any underlying instrument, readers can learn more about how they work here.

In short, those with currency exposure are not expecting the Pound to embark on a wild ride in the foreseeable future, and this largely rests with the view that the upcoming negotiations on Brexit are unlikely to deliver fireworks until the relevant deadlines come into view.

“Brexit is likely to increasingly become an issue again over the coming days. But in the end the scramble about the start of the second phase of the Brexit negotiations confirmed that the talks will only see a breakthrough when a deadline is approaching and ultimatums are presented,” says Esther Reichelt, an analyst at Commerzbank.

“The next deadline that is currently under discussion is only in October when it is hoped that the parties will have come to an agreement regarding a trade agreement. As little is likely to move on the Brexit front for now, and a further Bank of England rate hike is unlikely to be an issue over the coming months due to the rather weak economic outlook, GBP exchange rates are largely determined by external factors,” adds Reichelt.

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