A Month Out, and Options in the Pound to Dollar Rate can Finally Price in Brexit

The 23rd of March marked a milestone in that we are now three months away from the EU referendum. The countdown has begun.

The GBP has traded heavily in recent sessions, as the mild “risk-off” tone and heightened political uncertainty have weighed on the GBP to USD exchange rate in particular.

The ‘Brexit premium’ remains the key driver of sterling at present with the currency trading below where it should be were markets respecting economic fundamentals.

The declines come as the alternative to remaining in the EU presents questions and hence uncertainty that markets do not like.

Now that we are three months away from the date a big change in the FX markets has occurred - corporates can now start hedging their exposure to a weaker pound using options.

Options are typically dated on a three month expiry.

“Yesterday provided an indication of the risk premium being “priced-in” for the EU referendum, as options with a 3 month tenor included the decision date – 23rd June – for the first time,” notes Robin Wilkins at Lloyds Bank.

So what happened on the first day of ‘Brexit trade’?

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“There was a surge in 3-month GBP volatility, and the 3-month GBPUSD risk reversal showed its strongest bias towards puts (protection against decline in GBPUSD) since the 2008-09 Financial Crisis, surpassing both the Scottish Referendum and UK General Election in terms of extremity,” says Wilkins.

Looking at the odds ascribed by the betting markets, which reflect closely with the odds held by major analysts we note the chances of an Out vote have risen.

Paddy Power has narrowed its odd on Brexit to 7/4 down from 2/1.

In other words, chances for an exit have risen to 36% from 33%.

Betfair has shortened odds to 36%.

Bet 365 and Sky Bet have narrowed their odds to 40%.

The latest ICM poll of voter intentions meanwhile shows the Out vote has the lead, but note how the odds markets are a better guide to FX reaction than the pollsters.

A marked increase in the Out vote over coming weeks would trigger a move higher in the betting markets, and hence some real downside risks to GBP would likely emerge.

Meanwhile, the dollar strengthened yesterday as US Fed Member Bullard indicated yesterday that there may be a case for raising interest rates as early as April, given the possibility of overshooting inflation and unemployment targets.

This added to recent hawkish comments from Fed Members Williams, Lockhart, and Evans.

Are the Fed actively trying to price the USD higher?

The answer is probably not, but from where we are sitting it does look pretty coordinated and could spell for a stronger dollar going forward.