SocGen: "The Pound Short Covering May Just Be Starting"

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One day after Deutsche Bank quickly flipped its bearish outlook on the British pound after Theresa May announced snap elections in June, calling the announcement a “gamechanger” and saying “we have been structurally bearish on sterling for the last two years but are now changing view. We are closing out all our bearish FX trades”, today it was SocGen’s turn to ask rhetorically if “the worst may be behind us and cable short covering may just be starting.”

 In short: another bank has flipped bullish and is urging clients to squeeze cable shorts, only instead of doing it directly by buying GBPUSD outright, SocGen comes up with a novel trade, specifically one in which SocGen recommends selling downside and volatility as follows:

Buy GBP/USD 3m seagull strikes 1.24/1.32/1.35; Zero cost (indicative, spot ref: 1.2850); The strategy has an initial delta of about 35%, is short vega, and almost no theta on the upside.; The market value is hurt if the spot falls but recovers to flat provided that the spot is above 1.24.

 

A key objective going forward is 1.3450/1.3505.

Here are the full details:

GBP/USD: Is the worst behind us?

Rationalte: Brexit negotiations: better prospects

Prime Minister May surprised the market by calling for a snap general election on 8 June. The possibility of a hard Brexit has already been discounted by the market, but the larger parliamentary majority currently implied by the polls (chart below) would strengthen the UK government’s negotiating position domestically. The market is now assigning better odds to a post-Brexit EU-UK trade agreement, and thus the worst may be behind us and cable short covering may just be starting.

Positions set to shift

The options market is seeing a wave of unwinding of medium-term bearish puts as the 1y GBP/USD risk reversal has softened to its lowest level since end-2015. Risk reversals have led the spot positioning in the past, and the latter is still exhibiting extreme shorts.

– Milder economic impact

The freshly released IMF WEO now forecasts UK growth of 2.0% this year, upgrading the January forecast by 0.5%. This reverses nearly all of the downgrade it pencilled in after last summer’s Brexit vote (1.1% was forecasted in October).

– Bullish technical signal confirmed

The scenario in the Chart Alert published by our technical analysts materialised overnight, with cable breaking the 1.2780 high. A key objective going forward is 1.3450/1.3505.

Expression – Selling downside and volatility

– The technical/macro/political picture makes us more comfortable financing a call spread via downside options.
The resulting seagull structure is short volatility, consistent with the view of a higher spot on the back of a brighter economic outlook and reduced political risks.

Mechanics – Buy GBP/USD 3m seagull strikes 1.24/1.32/1.35

Zero cost (indicative, spot ref: 1.2850)

– The strategy has an initial delta of about 35%, is short vega, and almost no theta on the upside.
– The market value is hurt if the spot falls but recovers to flat provided that the spot is above 1.24.

Risks – Unlimited below 1.24, flat between 1.24 and 1.32

Our seagull exposes investors to unlimited downside risk if cable trades below the 1.24 strike in three months.

The trade is flat at expiry between the 1.24 and 1.32 strikes.

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