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Volatility, Mixed Liquidity Dominate Sterling Market Ahead of Brexit Vote

With just a week to the referendum that’s going to show
whether Britons want the UK to stay in the EU or not, sterling trading appears
to be dominated by increased volatility and mixed liquidity across different
market segments.

“Trading spot is certainly still possible, but not advisable
unless it is for hedging of existing exposures,” says John Hardy, head of FX
strategy at Saxo Bank. “We don’t know what reaction we can get and the price
swings in the wake of the referendum result could be extreme.”

He adds that, “on the options side, it is still possible to
speculate, but implied volatility is very high, as you’ve seen with sterling/dollar
volatility, which was near 40% recently for two-week options.”

On the other hand, Craig Erlam,
senior analyst at Oanda, says, “We still see a good level of liquidity in the
spot market for sterling/dollar, as the increased volatility is still creating
opportunities for traders.

“That said, I would expect to see a
drop in liquidity from Thursday onwards,” he adds.

Amid increased volatility, a divide appears to be arising
between retail and bank segments, with the former seeing higher levels of
liquidity compared to what appears to be happening among banks.

This is partly explained by the suggestion
that “institutional players are a bit more cautious heading into the referendum,
as they have been focused on reducing exposure and mitigating risk”, according
to Joel Kruger, FX strategist at LMAX Exchange. He adds that on the other
hand, retail players “still have access to plenty of leverage, which makes the
retail market a bit more dangerous right now”.

The weakening of sterling has resumed in recent weeks against
other major currencies, after it had looked steadier earlier.

EUR/GBP has moved up by more than 5% in June from
around 0.7600 towards 0.8000.

Meanwhile, Cable over the same period has fallen from a high
of 1.4600 to a low below 1.4100, a 3.4% move.

“This surge in volatility also
coincides with the purdah period (since end of May) where the government has
not been able to publish any material warning of risks associated with leaving,”
says Kruger. 
“This has certainty helped the leave
side in the sense that it has fuelled the momentum shift and added a layer of
uncertainty.” 

Kruger adds, however, that renewed
warnings of the risks associated with a vote to leave might resume after this week’s meetings of the Federal Reserve Bank,  Bank of England (BoE), Swiss National Bank (SNB) and Bank of Japan (BOJ). This week the
 Fed, SNB and European Central Bank (ECB) have all reiterated their
concerns over the economic impact should Britain vote to leave the EU.

Hedging

Meanwhile, hedging looks increasingly focused away from
sterling and on other major currencies.

“For those looking for some kind of hedge over the Brexit
there are a few options, you can take a position in currencies that are likely
to be correlated with the move,” says Hardy.

“EUR/USD is likely to have some degree of reaction to
the event itself, or USD/CHF,” he says, adding, “These kinds of
trades are more tradable, the spreads are more orderly and the market is
more liquid.”

Trading EUR/USD was the most favourable alternative,
according to Kruger, as currencies other than the dollar were surrounded by
uncertainty over a possible intervention of national central banks.

“There has been a lot of talk about hedging Brexit risk via
EUR/JPY and EUR/CHF, but I don’t like that hedge as much given BOJ
and SNB policy that is unwelcoming of currency appreciation and very capable of
an intense intervention response,” he says. “Shorting the euro and buying the dollar
is more attractive in my view as the dollar is ultimately a safe haven
currency and if the market gets nervous, it will benefit from this
flow.”

Intervention Expected

With the vote getting closer, questions remain about what is
going to happen from 23 June
 onwards.

“There is an assumption that the vote will have a black/white outcome,”
says independent strategist Olivier Desbarres, adding that on the contrary,
“There are potentially different outcomes as there could be a very close vote
and there’s pressure on the government to hold another referendum.

“The leave vote might win, but it’s not clear-cut whether this will be
binding for the government who might ultimately ignore the referendum result,”
he adds.

In the event of Britain voting to leave the EU, the ECB would
“publicly pledge to backstop financial markets in tandem with the Bank of
England,” Reuters reported Tuesday, citing anonymous sources.

The liquidity intervention would involve opening so-called swap
lines with the BoE, allowing euros and sterling to be exchanged, Reuters reported.

“It makes perfect sense” says
Hardy.
“You’re going to see
some kind of smoothing operations if we do see a Brexit. It’s something the Fed
did back during the financial crisis.”

“It means that the central banks will help keep volatility at
more like 5-10%, rather than allowing chaos and something like 25% moves in the
event there is simply no liquidity in the hours after the result is in,” he
adds.

Beatrice Bedeschi

beatrice@profit-loss.com

Twitter @Profit_and_Loss

To hear more about this topic, tune in on June 21 to our webinar: The Potential Impact of a Brexit on Global Currency Markets

Beatrice Bedeschi

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