authored by

John Kierans
September 2019

This is the first time we have published a comment on a position or trade that we have instigated.  But given how topical Brexit is we thought readers might be interested in our approach.

We take an extremely disciplined and tactical approach to trading and are using combinations of futures, put options, put spreads and possibly covered calls to implement our trade. I have tried to write this commentary in nontechnical language, avoiding unnecessary jargon.

I will first define our time horizon, our basic (imperfect) assumptions and then explain why we have chosen the Pound Sterling as the preferred conduit for our trade.  Finally I outline our ‘selling stories, buying facts’ approach.

Time Horizon

In my view the longer term success of the British economy is not overly dependent on their membership of the European Union.  It is possible that the British could enjoy comparative success inside or outside the EU.  Equally their economy could regress inside or outside the EU.  However in the shorter term, that is between now and Christmas, there is a potential for radical moves in British asset prices.  This commentary is exclusively focussed on very short term trade opportunities.

Assessing opportunities with BREXIT involves making a number of very basic ‘working assumptions’.  These assumptions are not meant to be perfect, but they are a start.  The table below indicates our view whether each outcome given is good or bad for the British economy with Boris Johnson or Jeremy Corbyn acting as Prime Minister. I have said nothing about the probabilities of these events and we must remember we are dealing within the context of a very short time horizon.  The table is only for 2019, it does not express our assumptions for 2020.

The first thing you may notice is that Corbyn is regarded as negative in all scenarios.  There is a striking difference between the leaders of the two main political parties.  Boris Johnson has a romantic, cinematic view of  Britain’s future with himself playing a starring role.  The political policies and actions required for this vision are little more than stage props.  In short, Mr Johnson is light-hearted and uninteresting.  Jeremy Corbyn is very different. He is a serious and intellectual man.  He is a committed socialist ideologue.  He has maintained strongly held and sincere views on a variety of issues.  Our working assumption is that British asset prices will have a short-term negative reaction if he becomes prime minister.    

Pounds / Bonds or Stocks?

In our view the best asset to take a position on is the Pound.  Capital flight out of the UK could cause a major (20%) move in the international value of the pound sterling.  The Bank of England’s ability to arrest a negative move is somewhat limited by its foreign currency reserves.  Central Banks generally find it easier to suppress the value of their currency by printing off new currency and exchanging it for foreign currency.  However the opposite is the case when a currency is devaluing.  They are forced to buy their own currency with whatever foreign currencies that they hold in reserve.  Aside from all of this there is no guarantee that the Bank of England would attempt to stop the pound from declining in value.

In short we think that the pound could take a sharp move lower in the event of either a hard Brexit or the election of Jeremy Corbyn before yearend.  Our preferred currency pair is the GBP.USD, which is often referred to as ‘cable’.  The US Dollar is relatively strong on its own merits.  We have three reasons supporting this strong Dollar view.

1. US interest rates will remain positive, unlike Euro and Yen interest rates.  

2. There may be a US Dollar shortage towards yearend.    Due to the Debt Ceiling debate over the summer the US Treasury is highly likely to increase its borrowing in the last quarter by $180bn. This extra borrowing required will create an extra demand for Dollars.

3. In recent crises the US Dollar has acted as a safe haven.

Our assumptions on where GPB.USD will move in various scenarios are graphically set out below.

As I write this commentary (Sept 2) cable is trading at 1.20.  Given that a hard Brexit cannot happen before October 31st it would be difficult for traders to push cable below 1 (‘parity).  No matter how certain a hard Brexit looks it cannot be 100% guaranteed that Britain will not reverse course.  Thus moves to the downside should be constrained or contained by this persistent doubt.  What we get between now and a potential ‘Hard Brexit Day’ (“HBD”) are stories and speculation about the potential HBD.  This raises the volatility price or riskiness price of cable put (downside) options.  

In plain English we will be enduring potential worst case scenario losses of approximately 2% of our assets under management on various trades over the next 8 weeks.  We view this loss as highly unlikely.  On the positive side we hope to arrive at a position in 8 weeks that leaves us with zero downside and a chance to profit by at least 10%/15% of our assets under management for a move down to 1.00 for GBP.USD before December 6.

This is a complex trade and we may not succeed in building it on our terms.


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