LONDON (Reuters) - For a currency that has seen some of its biggest ever one-day moves on the back of Brexit, there is a peculiar calm in sterling hedging prices surrounding December’s critical European Union summit.
For many, the Dec. 13-14 get-together marks a critical juncture in the process of Britain leaving the bloc, with some market analysts seeing it as a potential make-or-break moment for the pound.
At stake is whether Prime Minister Theresa May can satisfy other EU leaders that Britain has made enough commitments on issues like a final settlement bill and the Irish border to quickly start trade negotiations next year as the clock ticks down. Otherwise, the risk of economically-damaging ‘no deal’ Brexit rises dramatically.
Yet, even with so much at stake, options markets that reflect expected volatility around next month’s event and data on speculative sterling positioning appear largely neutral.
In fact, one-month implied volatility in sterling against the U.S. dollar is currently less than its 8.6 percent average of the past 20 years.
Traders still think the pound will be more volatile than other major currencies such as the euro and Swiss franc, though, and say the indication of calm is more reflective of the subdued price action of the most recent period, rather than of what could be in store.
“Sterling volatility has tended to remain higher even as FX volatility has declined, which suggests markets have a greater capacity to discount negative headlines,” said Timothy Graf, head of macro strategy at State Street Global Markets.
Implied volatility for sterling for one month against the dollar GBP3MO= is higher than three-month rates and stands at a chunky 8 percent. Sterling volatility against currencies such as the Japanese yen GBPJPY3MO= and the Australian dollar GBPAUD3MO= is even higher.
In comparison, three-month implied volatility for the euro against the dollar stands at a relatively tame 6 percent EUR3MO= while overall stock market volatility is within touching distance of a record low of 9 percent hit this month.
One factor making traders wary of translating signals from derivatives into trades in the cash market is that the former have thrown up some conflicting signals in recent weeks.
For example, three-month ‘risk reversals’ on sterling GBP3MRR=, which shows the relative pricing of puts and calls on the pound, consistently indicated a bias to further sterling weakness throughout the year even as the pound gained ground against the dollar. It is up 10 percent to date in 2017.
“As a result, betting on sterling via the options markets has been a bit of a money losing trade this year,” said a trader at a global macro hedge fund in London.
Still, that hasn’t stopped directional bets and the cost of buying sterling puts - options to sell - remain more expensive than calls - options to buy - and show some traders at least are assuming the outcome of the EU summit will be sterling negative.
Underlying structural factors for sterling have also worsened markedly in recent months, such as a widening current account deficit, prompting some money managers to call for the British pound to be traded like an emerging market currency at a Reuters Investment Summit last week.
(Graphic - Sterling Positions: reut.rs/2zVlp7u)
With few if any precedents for an event like Brexit to guide traders through the next month, large investors are harking back to trading patterns leading up to the referendum vote last year.
“The problem for investors is there are no historical references to form an expectation on something such as Brexit with a long agenda of negotiations leading up to it,” Pascal Blanque, who oversees 1.4 trillion euros at Europe’s largest asset manager Amundi told the Reuters Global Investment Summit.
As a result, some traders are taking recourse in the options markets, although expiries around the summit are less about taking directional bets and more about guarding against spikes in volatility.
What’s more, the one-month options that surround the crucial EU summit also capture key central bank policy decisions in both the United States and Britain.
“It is very difficult for investors to take a directional view given the mixed messages from politicians on the negotiation progress, therefore long volatility positions such as straddles are a good choice over outright cash bets,” said Jordan Rochester, an FX strategist at Nomura in London.
As a result, speculative bets on sterling are broadly flat, unlike before the Brexit vote, while institutional investors such as pension funds and sovereign wealth funds are broadly underweight the British currency in their portfolios.
With expectations for a major breakthrough in policy talks low, buying so-called “option straddles” which involves simultaneously selling and buying currency derivatives on either side of the summit have gained popularity.
A survey by Nomura showed that only 31 percent of its clients expected a Brexit transition deal to be agreed by January 2018, although a majority still think Brexit will go ahead.
But unlike the sharp run-up in volatility gauges in May-June last year, implied volatility on sterling remains a fraction of what it was in the final days before the Brexit vote suggesting some market participants are toning down their expectations for next month’s summit.
“Unlike the hard binary event Brexit vote last June, this is a summit and so markets are not getting too worried about this,” said SSGM’s Graf.
(Graphic - UK Current Account Deficit and Sterling: reut.rs/2AjL9Ly)
Reporting by Saikat Chatterjee; Editing by Mike Dolan and Toby Chopra