The cost of hedging against sharp swings in sterling surged to its highest in almost six years on Wednesday, three months before a June referendum on Britain's European Union membership, and coinciding with narrowing bookmaker odds on a vote to leave. Sentiment towards the pound has soured this week after the resignation of a senior pro-"Brexit" minister and criticism of finance minister George Osborne over his 2016/17 budget.
Sterling came under more selling pressure on Tuesday on a view that the deadly attacks in Brussels would boost the campaign to take Britain out of the EU and with latest opinion polls showing a tight race between those who want to leave and those who want to stay in the bloc. Trade-weighted sterling, a broad gauge of the pound's performance against a basket of currencies, fell to a more than two-year low while the implied volatility on three-month sterling/dollar options, covering the period that includes the "Brexit" referendum on June 23, soared to 14.50 percent, the highest level since mid-2010.
Three-month euro/sterling equivalents rose to 13.50 percent, the highest since April 2009, according to Reuters data. This means those wishing to hedge against price swings have to pay around 13.5 percent premium over the spot price of the underlying option. Options give holders the right to buy a currency at a pre-set exchange rate at a specific future date and are used either as protection against big swings in the rate or as a way to speculate on such moves taking place.
The three-month sterling/dollar risk reversals, a gauge of demand for options on a currency rising or falling, showed an increasing bias for sterling weakness against the dollar. They traded at 4.8 vols - a measure of volatility - compared with 2.4 vols in favour of sterling weakness on Tuesday.
According to Reuters charts, these were levels last seen in the wake of the May 2010 general election, which resulted in a coalition government, and show a bigger skew in favour of sterling weakness than seen during the global financial crisis in 2008. "Implied volatility on three-month options now captures the June 23 date. These are clean instruments to express concerns regarding the vote," said Ned Rumpeltin, European head of currency strategy at TD Securities.
"Brexit is a very big deal for the UK economy and if Britain leaves the EU, it could lead to a significant devaluation of the pound." Bank of England Governor Mark Carney, who has called Brexit the biggest risk to domestic financial stability, chaired on Wednesday a meeting of the central bank's Financial Policy Committee - its last scheduled before the June 23 referendum. The Bank has taken steps to keep markets running smoothly during the time of the vote, saying it will offer extra funds to banks.
STERLING SLIDES In the spot market, sterling fell to $1.4115, down 0.7 percent on the day. It also hit one-month lows against the euro. On a trade-weighted basis the currency fell to a more than two-year low as polls highlighted the close race for the referendum.
The ICM opinion poll of 2,000 people, carried out on March 18-20, put support for the "in" campaign on 41 percent while that for the "out" camp stood at 43 percent. Another by ComRes on Wednesday gave the "in" camp a lead, but by the narrowest margin since the May 2015 national election. Bookmakers' odds on Britain choosing to leave the EU have tightened in the past few days, having started to narrow after the resignation of Work and Pensions Secretary Iain Duncan Smith on Friday which he said was over welfare cuts proposed in last week's budget. The government said on Monday the planned cuts would not go ahead.
The resignation highlighted a deepening rift within the ruling Conservative Party. "We see the pound staying under pressure ahead of the 23 June Brexit referendum," Hans Redekar, head of currency strategy at Morgan Stanley said. "The terrorist attack in Brussels and the Conservative Party looking more divided than in recent years do not bode well ahead of the vote."
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