GBP trader - G10 FX wildchild is behaving but for how long

UK politics is always interesting viewing, especially when you have the luxury of watching from the other side of the world and where the policy choices don’t directly affect you. Clearly, the disconnect between the Truss govt and the capital markets has been brutally exposed, resulting in an exodus of UK assets and requiring some heavy lifting from the BoE in response.

GBP has been the posterchild of volatility with GBPUSD 1-week (options) implied volatility trading to 29.4% - the highest level since March 2020 - and this won’t surprise given we saw a near 900 pip high-low range last week – the biggest trading range since 27 March 2020. Expected volatility has subsided thanks to the temporary resumption of the BoE’s long-duration bond buying measures, as well as the humbling U-turn on plans to scrap the 45% tax rate – while a strong global equity rally is also offering tailwinds for GBPUSD. 

The U-turn – but is there more?

The Tory party conference is currently in play and lasts through to Wednesday, and so far, the atmosphere has been incredibly downbeat – all the focus has been on chancellor Kwarteng being forced to walk back his highly unpopular top income tax plan. The market understands this action almost had to happen to avoid a complete implosion of the Tory party, and at the margin does take some pressure off Truss and the BoE – where we see the UK rates market pricing out 30bp of hikes to price the BoE ‘s bank rate at 5.59% for the May 2023 meeting. This is the point where the market sees the highest pricing (or ‘terminal’) of BoE’s bank rate in the future. 

The question for traders is whether this move is a signal for a full reversal of all the measures announced in the ‘mini budget’ last week. On its own, the U-turn on the top bracket tax plan is not a game changer for the GBP as it represents just 4.5% of the expected £45b cost of which the govt would need to reach out to the capital markets to borrow. 

However, if the U-turn is really a precursor to a full unwind of the fiscal stimulus, then that is a genuine GBP positive, as it would reduce expectations of an increased governments funding requirement over the coming 2 years and therefore higher borrowing costs – interestingly, we’ve seen headlines that at least two cabinet ministers say the “Truss project is over” because she failed to bring them along on the key policy objectives. 

While GBPUSD has already easily reclaimed the level of 1.1274 it was trading before the mini budget, it feels like if we were to hear an announcement of a full reversal of the budget measures then GBPUSD could squeeze past 1.1400. If and when this announcement comes is a major consideration, but we may need to see renewed selling of UK bonds (gilts) and further GBP downside to put enough pressure on the Truss govt to take this fairly radical action. 

What if the current fiscal measures do pass through the Commons?

We should consider the scenario where the remaining fiscal measures are passed when voted on when parliament resumes on 11 October – this is the scenario where we may be getting to levels that interest GBP shorts, certainly against the crosses. The fact that so many GBP shorts have been flushed out has led to a far cleaner position. We also know that the BoE’s long-dated bond buying program ends on 14 October – this was announced last week to save the UK pension industry and it worked well in bringing down long-end gilt yields and promoting massive GBP short covering – but it ends soon, so then what?

There is also the very real prospect that either Moody’s or S&P downgrade the UK sovereign credit rating, which would be a genuine embarrassment for the Truss government. The result of the review is due on 21 October, although these agencies may wait until 23 Nov when Chancellor Kwarteng lays out his budget and the Office for Budget Responsibility (OBR) offer their forecasts for the fiscal year. 

Pricing risk in the GBP

With such uncertain circumstances, pricing risk in the GBP is challenging and that commands a higher volatility regime. We do get some impactful data between 19-21 Oct (UK CPI, housing data and retail sales) which could impact UK interest rate pricing for the 3 Nov BoE meeting, where 120bp of hikes are priced, and this could compound the volatility in the GBP. 

For now, though, GBP traders are positioning exposures around expectations of what fiscal program passes, and the supply in bond issuance – they are watching equity markets and if the S&P500 pushes higher then cable could have a look at 1.1400+. 

Shorting GBP is tough right now, but the preference is to sell weakness and go with the flow and momentum - a break below 1.1086 is not as far away as it seems and that would encourage GBP shorts again.