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Are you prepared for a spike in FX volatility?

Are you prepared for a spike in FX volatility?

Chris Towner Weekly bulletin December 2018
The Queen described 1992 as an ‘annus horribilis’ as it contained one disaster after the other. Prince Andrew divorced Sarah, Princess Anne divorced Mark Phillips, Diana published ‘Her True Story’ and The Queen’s beloved Windsor Castle was devastated by a fire. For those of you that remember, 1992 was a pretty bad year for Sterling too, as it crashed out of the ERM.

Similarly Theresa May has just come out of a tough week. While the nation enjoyed its Christmas parties, Mrs May had been gallivanting around Europe. She has been trying to shore up further legal and political clarifications to allow the Irish backstop to be clearly temporary. Her efforts have fallen on deaf ears. If that wasn’t enough she has also been attacked on the home front. On Wednesday she had to contend with a vote of no confidence. She did survive but not without chinks in her armour.

Whatever your views on Theresa May, you have to agree that her job has not been easy and she is certainly tenacious.

So where do we go from here in the Brexit negotiations? There is so much at stake, so little agreement and so much uncertainty.

Generally, uncertainty breeds volatility in financial markets. In 2016 the referendum unveiled extreme volatility with GBP/USD suffering its biggest one day move in history dropping from 1.50 down to 1.32. That’s a 12% move in one day and is equivalent to the average range we see in GBP/USD for a year. So given all the current uncertainty, why has GBP/EUR been so quiet this year?

GBP/EUR is acting like a coiled spring. There is no movement currently but with massive potential energy for a large move to happen. But in the meantime we wait.

So far in 2018 GBP/EUR has ranged between 1.0986 and 1.1549. That’s a mere 5.28%, less than half the average of a typical year. Brexit was priced into the market in 2016. Now the outcome is again binary but it is more like an after-shock to the original quake. A hard Brexit has the potential to push GBP/EUR lower to test parity, whereas a negotiated deal has the potential to drive this currency pair back up to 1.25.

What if there were to be another referendum and the UK remained in the EU with her tail between her legs? This would lead to significant Sterling strength but at the same time would leave a lot of people feeling ‘democratically’ robbed.

The Europeans feel that if they concede on the Irish backstop and the deal doesn’t go through UK Parliament then what else will they be expected to concede on? The cliff edge is fast approaching and the tick of the clock is getting louder.

One thing for certain is that it is unlikely we will see another quiet year for GBP/EUR. If you have risk within your business or on fund level and you are considering hedging it, it is far easier to plan your strategy in a low volatility environment. Low volatility gives rise to a low level of emotion and therefore it is easier to plan. High levels of volatility drive up the cost of hedging and increases the levels of emotion involved in the planning process. An outcome will come. Hard Brexit, soft Brexit, no Brexit or postponed Brexit. Whatever the outcome, you can expect a sprinkling of volatility to accompany it.

For more information, please contact Chris Towner, Director at Chatham, at ctowner@chathamfinancial.com.


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