- J.P. Morgan exit trade seeking to profit from EUR/GBP volatility

- "We can't ignore the benign price action in GBP indefinitely"

- But Commerzbank's Jones says Euro likely to suffer continued "negative bias"

The Chase Tower, New York © Kristen Cavanaugh, reproduced under CC licensing.

The months-long malaise in EUR/GBP price action has forced strategists at J.P.Morgan to abandon their call for a pickup in volatility this year just as the tennis match between Britain’s currency and its continental rival was about to become more interesting.

Six months of range-bound trading has seen Sterling slip and slide back and forth between the 1.10 and 1.15 thresholds in an entirely orderly fashion that has belied the risks posed to the currency by politics on either side of the English Channel.

The J.P. Morgan team had been using complex derivatives as part of a strategy to profit from volatility they expected to hit the currency market were Brexit negotiations took a turn for the worse and a “no deal” Brexit forced its way back onto the agenda at the crucial European Council summit held in March.

However, with the summit having heralded unanimous agreement among European leaders to approve a so-called transition deal and enable negotiations to move along to the subject of trade, Pound Sterling ticked higher against the Euro in March but ultimately has failed to make a substantial break in either direction.

"Investors have been reassured that the UK will eventually agree a negotiated exit from the EU to include a 2Y transition period and that to all intents and purposes Brexit has been relegated as a secondary macro-economic driver for GBP,” says Paul Meggyesi, vice president of global currencies and commodities at J.P. Morgan, in a recent note. “We believe this assessment is too sanguine – after all it is hard to dispute that Brexit is in fact already depressing UK growth and will likely continue to do so - but then again we can't ignore the benign price action in GBP indefinitely."

The result of this “benign price action” in the EUR/GBP rate was that the JPM team’s bet on an uptick in volatility began bleeding losses into their broader portfolio, leading them to abandon the bet last week.

This decision comes three months after the J.P. Morgan team booked losses on a bearish bet against the Pound, back in December, and took a hiatus from making “directional calls” on the Pound in favour of betting on volatility instead.

However, the decision to exit the volatility trade comes as the exchange rate threatens to break out of its six month long trading range.

“Sterling closed last week in fine form and could be set for more this week, though there are few notable event risks on the calendar. UK rates continue to push at the highs for the cycle, while Eurozone rates have been dribbling lower for weeks. Is it finally time for Sterling to make a move against the Euro?,” asks John Hardy, chief FX strategist at Saxo Bank.

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“One of the few interesting compelling developments at the moment is the attempt through major support in EURGBP,” Hardy continues. “It is tough to draw a bead on any specific catalyst for this move, but rising UK rates while ECB expectations have collapsed provide some support at the margin. Technically, a break of the sub-0.8700 area could open up considerable downside, where the lower range stretches to at least 0.8350. Fourth rejection of a break attempt or a new downtrend?”

Sterling’s advance against the Euro comes at what may prove to have been a pivotal time for the currency.

After all, and as Saxo Bank’s Hardy points out, markets are as happy as they’ve ever been to bet the Bank of England will soon raise interest rates again but are becoming more and more sceptical of when the European Central Bank will manage to complete the winding down of its quantitative easing programme.

“EUR/GBP continues to sit at the base of its range. Near-term it is struggling to overcome resistance at 0.8800/0.8810 and while capped here, a negative bias remains," says Karen Jones, head of technical strategy at Commerzbank.

Jones says a close below 0.8697 is needed to confirm the market is ready to head lower towards the 78.6% retracement at 0.8527 (of the move up from the 2017 low).

"The intraday Elliott wave counts remain negative and we have a confirmed sell signal on the Directional Movement Indicator so we will hang on to our short positions for now,” adds the analyst.

Markets are now looking to the Bank of England's meeting in May for its next move and an updated view on the economy.

Pricing in interest rate derivatives markets, which enable investors to protect themselves against changes in interest rates while providing insights into expectations for monetary policy, implies a May 10 Bank Rate of 0.66%.

This suggests a near 70% probability of another rate hike next month.

“We do not expect the MPC to be swayed from hiking rates next month. We expect the gradual easing of Brexit uncertainty along with increased wage growth to be compelling reasons for the BoE to act,” says Derek Halpenny, European head of global markets research at MUFG. “So, the Pound is likely to remain well supported ahead of the MPC meeting on 10th May.”

These views have been encourage by the Bank of England itself after it warned in February that interest rates will rise faster and further than the market was giving credit for if the inflation picture evolves in line with the latest set of forecasts from the Bank.

It predicted the consumer price index, which reached 3.1% in November 2017 and has since slipped back to 2.7%, will remain above the 2% threshold until at least the first quarter of 2021.

“Yields in the euro-zone have fallen notably of late, in large part due to global factors and ECB rhetoric emphasising the need for patience in reversing the current monetary stance. This has helped contain enthusiasm for the Euro in the foreign exchange market,” Halpenny adds.

The European Central Bank told markets in December that it would cut its quantitative easing programme in half this January, which it did, and that its intervention in the bond market would continue at a reduced rate of €30 billion of purchases per month until “September 2018 or beyond”.

Markets had originally hoped that it would cut the programme dead in September but a recent run of poor economic data has economists increasingly flag the possibility the ECB continues its bond buying until year end.

“The ECB has succumbed to rearguard foot-dragging as it considers the exit from QE (we now expect a third taper in Q418) while confidence in EUR has been damaged, albeit not irretrievably we believe, by the slide in growth momentum in the region,” J.P. Morgan’s Meggyesi notes.

An end to quantitative easing matters for the Euro because when the ECB ceases its intervention in the bond markets, yields will be able to rise, which may then prove a powerful lure for international investors who would have to buy the single currency before they can invest in Eurozone bonds.

However, if markets become more pessimistic about an end to quantitative easing during weeks ahead then, assuming they’re still happy betting on a Bank of England rate hike in May, the Pound rate may finally garner the momentum necessary to break out of its six month range against the Euro.

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