The UK Pound Crash Is a Big Wake-Up Call to US Traders Ahead of the Election

London (Oct 9)  The shocking overnight plunge in the pound — one of the world's most-traded currencies — draws attention to how outsized volatility can take the markets by storm.

While the pound's sudden meltdown has been blamed on computer-driven orders, vocal fears the U.K. is marching towards a hard Brexit already helped to send the currency tumbling to historic lows this week. But there's a bigger event risk lurking that could roil financial markets from Shanghai to Johannesburg: the U.S. election.

Investors are expecting a degree of volatility around the event, but they aren't sufficiently hedging the outcome of the U.S. election, says Citigroup Inc. Head FX Strategist Steven Englander. In a recent note, he observes that "investors will be surprised at how fast and far asset markets move on the news of a Trump or Clinton victory, and how little chance they have to profit from the news."  

While emerging-market assets might bear the immediate brunt of a Trump victory, according to market participants surveyed by Citigroup, investors aren't adequately hedging U.S. election risk, says Englander.

However, Englander suggests this abrupt move to sell sterling could serve U.S. investors as a wake-up call.

He says that muted investor positioning for event risks — from Brexit, the U.S. election, and other geo-political events, more generally — might be due to the fact investors are reluctant to "pay a premium in a year when returns are modest," and also the hope that they will be able to position themselves properly after a given event. "Because of this reluctance to pre-position implied volatility in FX, emerging markets and rates looks to be very low relative to the underlying risk," he notes.

Investor complacency could be setting markets up for a volatile sell-off in the aftermath of a risk event such as the U.S. election when everyone moves at once, he concludes.  "If everyone is positioning to pull the trigger on positioning as soon as they know the outcome, the repressed volatility may emerge in a very sharp burst," he points out. "The outcome would likely be that prices move much more quickly than expected with much less opportunity to get the position on than investors would like and some possibility that one-way markets lead to overshooting." Englander doesn't specifically cite the prospect of a Trump victory as a driver of volatility, as other analysts have.

Muted investor positioning for risk events might be because there's little clarity on how to trade the risks of a U.S. election, aside from popular calls on the Mexican peso, says Martin Enlund, chief currency strategist at Nordea Markets, citing a "relative lack of realized volatility" in the euro's performance against the dollar following the Brexit vote. 

"We also think volatility will head higher over the course of fourth quarter, after being depressed in recent months," he concludes, citing risks ranging from the Fed, the U.S. election to China.

SOURCE: Bloomberg