If you like a paradox you might be no stranger to unravelling self-contradictory statements like ‘this statement is false’ or ‘I am lying’, or perhaps puzzled over Achilles’ tortoise. But there’s an apparent paradox unravelling in the foreign exchange market this week. Following the release of the latest CFTC data over the weekend, it is apparent that there is still a significant long position left open within GBP markets. Of the speculative arm of the market, approximately a net 14% of open market interest is positioned to benefit from a rising Pound. This positioning has been trimmed in recent weeks with last week alone seeing long GBP positions squeezed some 3.7% alongside the falling spot price. Here’s the paradox: downside protection in GBP is now more expensive than contracts that provide equivalent upside exposure in GBP markets. So if participants are still positioned for an upside shift, why are they pricing for a downside move?
If we look behind the paradox this might be explained and give us an insight into where GBP might go. If the market is pricing downside protection as more valuable than upside exposure it represents a likely crowding of participants on one side of the market to sustain the imbalance. It is also therefore likely to reflect the market’s expected directional movement in the underlying spot price. As it stands in GBPUSD/GBPEUR markets, Sterling’s two major crosses, put options are consistently more expensive across the spectrum of traded contracts than equivalent calls, hinting towards a move lower in GBP. Options markets provide a more timely and reflective snapshot of the market than positioning data by virtue of being openly traded contracts. One potential explanation to unravel this paradox is therefore a time inconsistency: the positioning data is simply out of date.
There is some truth in this argument and the positioning data at the moment is playing catch-up with the spot price and balance of implied volatilities on each side of the options market. However, what provides a more comprehensive picture of the market is understanding that the options market is pointing in favour of a downside move to offset the open market’s long Sterling positioning. With a lack of fresh reasons to get behind the Pound, its favour has been slipping on the market. Accordingly, those with exposure on GBP are questioning their conviction in GBP given the year-to-date rally and a slow but sure long-squeeze in GBP has been underway. From this perspective, the downside skew within options markets should be read as a hedge against open market positioning.
With lagging vaccine euphoria hampering Sterling bulls, the short term Sterling outlook remains pessimistic. As England and Wales eased their respective lockdowns yesterday to allow non-essential retail and many outdoor hospitality venues to reopen, the Pound did enjoy some support. Data will be critical to the recovery with the spending by Brits in the coming days in the pub, restaurants and particularly retail to be watched closely to see how excess savings and pent-up demand translate into consumption and economic growth.
Discussion and Analysis by Charles Porter