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- Markets too relaxed about potential Pound Sterling volatility

- British Pound tipped to go higher in 2019

- Fair-value in GBP/EUR seen at 1.33

- PMIs hint at slowdown in Eurozone economy

Foreign exchange strategists at global banking group UniCredit are warning that markets are currently far too complacent with regards to the looming volatility Pound Sterling is likely to endure over coming weeks; but ultimately the Pound will ride this volatility and rally through 2019.

The Milan-based lender warn they think the market is underpricing Brexit risks when it comes to implied volatility for EUR/GBP, implied volatility is the expected turbulence in a currency at a future point.

In short, the market looks a little complacent as to potential risks judging by the low readings in implied volatility when compared to previous periods of huge moves in the currency.

"In our view, this suggests that the risk of a no-deal Brexit may be underpriced," says Kathrin Goretzki, FX Strategist with UniCredit Bank in London.

The E.U. and U.K. confirmed last week Brexit negotiations are at an impasse with the E.U. trying to muscle the U.K. into as close a union as possible, but Prime Minister Theresa May is keen to keep the bloc at arms length owing to intense domestic pressures.

The proxy for this tug of war is the incredibly complicated Irish border puzzle which has no easy answers.

In short, UniCredit believe the Pound could be about to wake from a relative period of slumber as the impasse increases both domestic risks to May and the chance of a 'no deal' Brexit taking place in 2019.

"Current market pricing looks benign compared to prior episodes of UK idiosyncratic risks. Given that decisions with a major market impact will likely be made over the coming weeks and months, we think implied volatility should be considerably higher," says Goretzki.

The view that the Pound might be due a big move chimes closely with technical studies of the GBP/EUR market which suggest the current period of consolidation in GBP/EUR is about to mature and give way to a more sustained directional move, either higher or lower.

The exchange rate has been pivoting around 1.1250 for months now, but in the opinion of analyst Trevor Charsley at brokers AFEX it is likely we will soon see a more determined move.

Fair Value is Higher, a lot Higher

For Sterling, the road ahead over coming weeks will be bumpy but according to UniCredit the destination is well defined: a Brexit deal will be struck that ultimately prevents a hard-Brexit 'no deal' taking place in March 2019.

"The question whether a withdrawal agreement between the U.K. and the E.U. can be reached and ratified remains the most important driver for sterling. We share the market’s optimistic take on the probability of a deal and expect the GBP to appreciate on the back of this outcome," says Goretzki.

How high can Sterling go in such an event?

According to analysis from UniCredit, the fair value estimation for the GBP/EUR exchange rate is currently somewhere around 1.33.

This is the level the exchange rate would be at if there were no Brexit uncertainties hanging over the economy and Sterling were purely tracking price differences between the Eurozone and the U.K. and other drivers such as interest rates and economic performance.

The Pound-to-Euro exchange rate is presently quoted at 1.1329, so is a fair distance away from a 'fair-value' of 1.33. This is because markets demand a discount on holding Sterling which is deemed to be a risky currency owing to Brexit uncertainties.

"Markets are pricing in a much higher risk premium given the risks related to Brexit," says Goretzki.

It is however unlikely that Sterling will rally to 'fair-value' in the event of a Brexit deal being struck as there are of course potentially years of trade negotiations ahead and no doubt further haggling over the terms of the U.K.'s withdrawal from the E.U.

So those looking for a stronger Sterling would be best served by curbing their enthusiasm and being realistic as to what levels the currency can achieve, particularly against the Euro which might benefit from an interest rate hiking regime at the European Central Bank from late 2019 onwards.

UniCredit hold a fourth quarter 2019 EUR/GBP forecast at 0.85 under the base-case scenario that a disruptive, no-deal Brexit is avoided.

This gives a GBP/EUR exchange rate of 1.1765. This is still well above the level forecast by consensus. Download the Horizon Currency report detailing where 48 of the world's main investment banks are forecasting GBP/EUR to be in 3, 6 and 12 months, this includes targets from J.P. Morgan, Goldman Sachs and Citi.

Brexit is currently held by the analyst community to be a largely binary event for Pound Sterling with significant downside risks being expected in the event of a disruptive 'no-deal' scenario taking place.

"The risk of a no-deal Brexit is low but non-negligible and would likely cause another period of sharp sterling depreciation. We would see risks of EUR/GBP breaking above 0.95 in the near term," says Goretzki.

A move above 0.95 in EUR/GBP gives a move below 1.05 in GBP/EUR.

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Euro Outlook Darkens Amidst Notable Slowdown in Activity

Survey data for October point to a significant slowdown in the Eurozone economy at the start of the final quarter of 2018, primarily due to weakness in Germany and broad-based sluggishness in manufacturing.

The Markit Eurozone Manufacturing PMI for October read at 52.1 where markets had forecast a reading of 53.0. The Service PMI read at 53.3, below the forecast for 54.5. The composite PMI read at 52.7, markets had forecast a reading of 53.9.

The data confirms business growth to now be at its slowest in two years.

"We see little to cheer about in the headlines from Markit. New orders growth slowed across the board, and output growth in both manufacturing and services slid to multi-year lows. To boot, executives’ outlook deteriorated sharply too," says Claus Vistesen, Chief Eurozone Economist with Pantheon Macroeconomics.

Vistesen believes these poor data will put the ECB, and its new-found confidence, on notice.

"Mr. Draghi’s words will be weighed carefully tomorrow," says Vistesen referencing Thursday's European Central Bank meeting which forms this week's highlight for the Euro exchange rate complex.