June’s Purchasing Managers indices set the stage for the latest bout of sterling weakness when they were released two weeks ago, showing the UK economy in contraction in the second quarter. Since then GBPUSD has reached its lowest level since April 2017.
Given GBPUSD has fallen more than 13% from 2018’s highs to last week’s lows, it’s tempting to conclude that weak growth and Brexit risk are already in the price for sterling.
We disagree – compared to the fragile state of the UK economy and its susceptibility to further Brexit shocks, fixed income and option pricing suggests that markets may even be complacent to sterling risk.
This suggests further downside surprises in the form of poor data, ongoing regional malaise, and of course Brexit have the potential to push sterling significantly lower, even before the October 31st deadline for Brexit.
Chart: GBPUSD lowest since April 2017
Compared to the Fed, markets aren’t pricing much action from the BoE – yet
Compared to the darkening macro and political outlook for the UK, fixed income and options market pricing is looking rather tame, or even complacent.
Fixed income pricing has been cautious about the Bank of England’s likely response to the current UK slowdown – OIS contracts for the December MPC are currently trading at a yield of 0.6%, only 15 or so basis points below bank rate.
Fed OIS, in the meantime, is fully pricing three cuts from the FOMC by December.
Chart: Market Pricing of Fed and BoE December meetings shows sterling has further to fall
Implied volatility from GBPUSD options markets, in the meantime, is trading at around 8.5% – compared to above 13% in late 2018 during May’s attempts at passing a withdrawal bill through Parliament.
In this context, Tuesday’s labour market report and Thursday’s Retail Sales figures will be crucial tests for sterling.
Employment was a rate bright spot in June’s PMIs so any weakness here would be a particularly unwelcome surprise.
Conversely last week’s BRC retail sales monitor was very weak, while consumer credit growth and savings intentions both point to some degree of belt tightening from UK households.