Worries over an exit of Britain from the European Union have taken their toll on Sterling. As June 23rd approaches, the day in which Britons will vote to either stay or leave, so does the pressure on the Pound Sterling mount. Media polls are failing to indicate a clear result, and the FX market is getting nervous. And yet, a Brexit seems unlikely and when markets price in the unlikely—even partially—it’s worth taking the other side.
Why A Brexit Still Seems Remote
The risk of a Brexit is mostly economic. Warnings of the financial calamity that could hit the UK have been coming from notable economists from the UK Treasury but the most noteworthy and important warning came from the Bank of England.
The Bank of England Governor, Mark Carney, delivered a stark warning in his latest conference. Carney laid out a rather bleak scenario in case Britons choose to exit the union. The BoE Governor stressed that growth would falter, unemployment would jump and inflation could spin out of control.
As I have stressed before, Britons are too well off to choose Brexit, despite what the polls say. With unemployment in the UK as low as 5.1%, consumer spending at record highs and GDP growth, though not robust, is at a fair pace of 2% with plenty of upside.
Under such circumstances Britons are not likely to choose Brexit, being the economic risk that it is. Sometime in the more distant future, when the Euro deteriorates into another chaotic episode, the ground might then be ripe. But that is currently not the case and that is why it’s hard to see Britons bring such pain upon themselves. Rather, Britons would likely cling to the British Prime Minister’s pledge to negotiate a better deal for the UK inside the EU after the referendum. And a better deal for the UK, despite discontent in Berlin and Brussels, is warranted.
Meanwhile, In The FX Market
Although a Brexit seems unlikely, no one wants to be caught with their pants down. Instead, corporates facing potential economic downside and investors facing potential losses would rather pay for hedging the unlikely than be blamed for not protecting themselves.
Data from the ICE Exchange shows that investors have crowded into call options for a Sterling short. Or in simple words, investors have bought into options that rise as Sterling falls. The chart below measures the ratio between the calls and the puts on a Sterling short. The higher the ratio, the more investors are hedging against a drop in the Sterling. And clearly, that ratio is shooting through the roof.
Chart courtesy of the ICE Exchange
That ratio is unlikely to change until June 23rd when the actual vote on UK’s future in the EU will take place. Because, until then, the polls will fail to dispel risk and investors won’t have a choice. But once the unlikely fails to happen, on June 24th, short bets on Sterling will be squeezed. Sterling could return to trading on its fundamental value and gain strength vs. the shaky Euro and the low yielding Yen. Though the Sterling is not likely to gain against the Dollar that continues to benefit from a hawkish Fed.
Sure, a Brexit could happen. After all, we don’t own a crystal ball. But those that are willing to take the risk that the unlikely will not likely happen could potentially ride a very lucrative trade.
Look for my post next week.
INO.com Contributor - Forex
Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.