by Ron Leven.
A 23 June referendum on British exit from the European Union (BREXIT) was set by Prime Minister Cameron on 20 February. As seen in the chart below, the trade-weighted GBP was in decline before the 20th as the market was already pricing for a potential BREXIT. The downtrend continues and the index is now at its weakest point since 2013 and showing no signs of basing. Volatility also began to firm late last year with a sharp acceleration in January. Although 1-month volatility appears to be capping out at around 9%, by historic standards, this is very high.
While the debate continues on what the implications of BREXIT are for the UK economy and GBP (more on this later), our data appears to show that the market is pricing for some combination of negative consequences and a significant risk that the referendum will pass.
The chart below shows the results of polling the UK public on the question of whether to leave the European Union (EU). The polls suggest that the market’s apparent pricing for a potential yes vote is not misplaced. While the no BREXIT side has generally been preferred by poll respondents, the difference is thin and the percentage of respondents opting for the yes BREXIT side has drifted higher in recent weeks. In the most recent (24 March) poll, 45% of participants indicated a preference to remain, with 43% preferring departure and 12% undecided.
Polling Results on the UK Leaving the European Union
Greece’s experience in recent years highlights the one-way nature of entry into the euro-currency area. The EU, by contrast, has an established protocol for exiting – although Greenland is the only region that has ever actually bolted. Cameron has announced that if there is a positive vote for BREXIT he will immediately apply to the EU for a UK departure. This would start a mandatory two-year waiting period of negotiations before the UK exit would become effective. The negotiation period can be extended with the agreement of both parties, but conventional wisdom is that EU officials would refuse. The chart below of GBP 3M risk reversal shows the skew for GBP puts vs. calls (or EUR calls vs. puts) is at its most extreme levels since 2010. The market is clearly biased that, even with the recent GBP declines, a yes vote on BREXIT is likely to send the GBP still lower.
There is a possible risk that barriers to trade between the UK and EU will emerge in the event of an exit. But even if no significant official blocks to trade emerge, UK trade with the EU could face increased paperwork, raising the cost of the movement of goods. In addition, there are other countries where the UK trade ties are defined by its EU membership – especially tax-free oil exports to Korea – that would also likely have to be renegotiated. Again, there is no guarantee that the results will not impede UK trade.
3M 25-Delta Risk Reversal Skew
There is much speculation in the press that London’s status as a global center could quickly erode in the wake of BREXIT. That speculation will run right up until 23 June. What is highly likely, though, is that trading of EUR- denominated financial products would be one sector at high risk of rapid migration to the continent. The European Central Bank (ECB) has expressed concerns in the past that the bulk of EUR related trading occurs outside the Euro-area and hence outside their jurisdiction. One of the chief motivations put forward in favor of BREXIT is separation from European political oversight – so it has been widely reported that the ECB would feel even less comfortable with London-centric trading of Euro-denominated instruments. And the ECB’s regulatory powers give it strong levers to compel banks to shift EUR related trading to Europe. This is a multi-trillion dollar business and the perceived potential loss would have a significant negative impact on London’s financial sector.
Some economic factors that could be contributing to support for BREXIT include predictions that it may end negative net transfers to Brussels and its potential to avoid adverse regulation. The primary motivations for BREXIT, however, appear to be political, including broad impatience with continental governance and the desire to establish local control over immigration.
While it remains moot whether BREXIT is broadly good or bad for the UK as a nation, the neutral observation is that market participants are pricing it as negatively impacting at least the short-term economic outlook.
As noted above, a yes vote on BREXIT would be followed by a 2-year period of negotiation between the UK and EU as well as with various other countries. It seems likely that this period would be one of great uncertainty and surprises – both good and bad – as agreements are hammered out. Given this, it would seem unlikely the market would price GBP trading to quickly return to normal in the wake of a vote in favor of BREXIT, but this is exactly what is priced in.
The chart below shows where the market priced GBPUSD and EURGBP 1M implied volatility at the beginning of the year and the beginning of this month for April, June, July and December. Consistent with what was indicated above, the chart shows a surge in expected volatility ahead of the June referendum. But the market is pricing a quick reversion of volatility after the vote. Implied volatility for the month of July is almost exactly the same as what was priced at the beginning of the year before the BREXIT referendum was set for June. And December forward implied 1M volatility also shows expectations that GBP trading will remain benign going forward.
The market expectations on EURUSD implied volatility also appear surprisingly benign. It would seem BREXIT is an important source of uncertainty for the EUR as well the UK. Not least because it might reawaken concerns about GREXIT– more on this below – and it could also influence ECB decisions on negative interest rates. As shown in the chart to the right, expectations for June volatility in EURUSD have firmed but remain far below the past year’s 15% peak. As with GBP volatility, the market is pricing for a quick reversion to the mean immediately following the referendum. Considering the uncertainties that could emerge with BREXIT, the implied volatility for July looks too cheap for GBP vs. USD and EUR. EURUSD July implied volatility also appears low and, indeed, the June market also seems to be underpricing volatility.
It was not long ago that GREXIT rather than BREXIT was the plat du jour, but now, Greece’s financial problems seem completely forgotten. The lack of concern would seem to be misplaced since there has been no improvement in Greece’s financial situation. Despite attempts at restructuring, the ratio of Greek government debt to GDP continues to creep higher and, according to Eurostat, was just below 180% at the end of last year. The lack of concern about Greece, in large part, reflects the ECB’s continued direct and indirect support to their bond market. The ECB will remain in a good position to provide support as long as they are engaged in quantitative easing. However, around the same time as the BREXIT referendum, it has been reported in the press that there is a bunching of maturing Greek Treasury Bills. Any indication that Greece is encountering difficulty rolling over this debt could be another potential source of EUR volatility in July.