Head of FX Strategy
Summary: The Tory leadership battle is engaged and the candidate list will likely be winnowed down to Boris Johnson versus a more centrist candidate, with Johnson emerging victorious on July 22. We are constructive on the long-term outlook for sterling if the narrative changes as we expect.
The only pro-Remain parties, the LibDems and the Greens/SNP, tallied together, only more or less matched the Brexit party’s vote count. The turnout was all of 37%, a real sign of Brexit apathy and exhaustion. The chief takeaway is that the next UK prime minister – and odds strongly favour this will be Boris Johnson – will have to deliver Brexit so the nation can move on.
The first round of voting for the Tory leadership election process saw Boris Johnson reaping 114 votes of the 330 possible, with the closest contender the more centrist Jeremy Hunt at 43 votes. The information value of that outcome is somewhat low, as the further winnowing of the candidates to the final two by June 22 will likely see the aggregation of the centrist/anti-Johnson votes, but we strongly agree with the oddsmakers’ view that Johnson is the overwhelming popular favourite and will emerge victorious when the vote tally of Conservative party members nationwide is tallied and announced on July 22.
Markets work on the basis of expectations, so a Prime Minister Boris Johnson outcome has been expected for some time. And in the wake of Theresa May’s leadership demise, the market narrative for the last few weeks has evolved into a sterling-negative one in which the two most likely outcomes are thought to either be a Hard Brexit or a Corbyn government. Let’s take the last of these first and dismiss it out of hand: the odds of an election scenario and Labour government look increasingly low and fading badly. Corbyn’s popularity is suffering on the general sense that he has only proven a weak opportunist during May’s struggles and besides, his platform is far too left of centre on economic policy to win a general election.
As for a Hard Brexit, we suspect there is a strong chance that a Prime Minister Johnson government will soon enough see the narrative shifting away from “Hard Brexit” to “Managed Brexit”. Boris Johnson stated in his Tory leadership campaign kick-off speech on June 12 that he would prepare the UK for a Hard Brexit to strongly signal to the EU that the UK is willing to go there as a matter of principle, even if it is not the outcome that he desires. The EU in the end will likely prove sufficiently impressed with the new leadership’s determination, and finally accept that it can’t bully the UK back to a Remain vote or into a humiliating arrangement that insults the UK’s sovereignty, as did the thrice-rejected Withdrawal Agreement. Instead, in coming months we could well see a shift to a more pragmatic approach.
What would a managed Brexit look like? There are too many moving parts to list here, but a basic outline could be a formal exit of the UK from the EU on October 31, but with a full-UK “backstop” of current customs union arrangements kept in place for now and at least until the end of 2020, perhaps with the proviso that the UK doesn’t strike any new trade deals that will apply during that transition period.
This would give the two sides time to hammer out a reasonable trade deal (if the EU is willing to make a free trade deal with Canada, it seems ridiculous to think that the EU will go to the wire insisting on harsh WTO trade terms with one of its largest export destinations). Other key issues like EU citizens’ rights are fairly straightforward, while the long lead time to late 2020 (or later?) on a new customs arrangement would allow time to develop a “digital border” to deal with the Ireland/Northern Ireland border issue.
One uncertainty and wildcard factor, if one that may tilt the risks more in the direction of pragmatism prevailing, is that all of the major EU institutions will see a leadership transition on November 1 – so the incumbent leadership will effectively be lame ducks from the end of June until then as political process is already underway now to appoint the new leaders, from the EU Commission President to the President of the European Council. On that front, it is hard to imagine a less UK-friendly combination than Juncker and Barnier proved since the Brexit referendum of 2016.
Trading Brexit outcomes
First, let’s make it clear that anything can happen and that the scenario could play out far differently from how we expect it to. Particularly over the coming couple of months, the price action could swing widely in both directions as uncertainties develop from headline to headline.
Risk allocation: we would look to establish half of normal risk allocation at this point in the early summer, looking to add another half if the endgame we envision begins developing as expected in the months to come.
Trading a longer term sterling-positive: establishing a time horizon
Boris Johnson has taken a strong stance on respecting the October 31 deadline, and it is clear that Brexit exhaustion is profound, so we’ll make the slightly risky assumption that there will be no further delays and that developments begin crystallizing ahead of that date, while allowing some further time after the date for a trend to develop – let's call it late November.
Core position: EURGBP puts, expiry late November
An example: (Spot reference on June 14 is 0.8905)
Long a EURGBP 0.8600 put, expiry November 22, cost: 58 pips
Assuming EURGBP is able to drop to half the distance from the post-Brexit lows near 0.8300 to the 0.8100 area that was the approximate highs/resistance before the Brexit vote (i.e., fall to 0.8200), the trade would deliver 342 pips or almost 6 times the amount risked. Of course, all funds risked on the premium are lost if EURGBP is trading at 0.8600 or above on the November 22 expiry.
Traders can also consider slightly higher or lower strikes that offer a higher break even price and more leverage, respectively, assuming EURGBP falls very far in the latter case.
One strategy to distribute the risk is to take half of the initial position now and half later in the event that GBP runs into some trouble over the summer, for example because the EU takes a tough stance initially as negotiations begin. The risk there is one of missed opportunity if EURGBP begins falling sooner rather than later and the upside is an opportunity to buy a far higher put for the second trade leg and thus raise the breakeven price for the overall trade. Another strategy is to hold some risk allocation in reserve for the GBPUSD call idea below.
Long term EURGBP chart: note the very wide range of EURGBP before and after the June 2016 Brexit vote.
But in the longer term perspective, the USD is terribly overvalued. We can’t price options at a hypothetical point in time in the future, but any surge in USD strength sows the seeds of its own demise as USD strength is terrible for growth and markets and will bring an eventual response. In a strong USD scenario that takes GBPUSD back close to 1.2000, for example, we could look to put on longer term risk (well into 2020) for far out of the money calls.
Follow on trades: we’ll update this article and strategy as the situation develops, but the market could be well on the move before all of the particulars are squared away, provided a diplomatic and pragmatic tone is taken and the outlines of the coming agreement are agreed in principle.
• The chief risk of any long volatility trade is that all of risk allocated to the trade (the options premium) can be lost, so investors should only allocate as much to a trade as it is acceptable to lose. EURGBP could trade much higher if some entirely other scenario than the one we anticipate develops and the UK is left in the lurch with a weakening economy and an exodus of capital.
• UK economic growth has been quite weak since the Brexit vote and our measures of the UK credit impulse suggest that the UK is headed for a rough patch growth-wise in the coming two-three quarters. That means that any boost to sterling will need to come through increased confidence and capital allocations back into the UK for the longer term more than any belief that this will result in an immediate boost to the UK economy.