Scots Stoke Volatility in Vote Seeking an End of U.K.Lukanyo Mnyanda and Rodney Jefferson
With the arguments for and against Scottish independence heating up before a referendum in three months’ time, dealers and strategists say there’s money to be made by betting on the fortunes of the pound.
Deutsche Bank AG, the world’s second-biggest foreign-exchange trader, recommends clients position themselves for more volatility in the currency before the Sept. 18 ballot by buying derivatives that profit from price swings. Pacific Investment Management Co., manager of the world’s biggest bond fund, said Scottish independence is more relevant to currency traders than bond investors.
“Buy volatility into the referendum,” Oliver Harvey, a foreign-exchange strategist at Deutsche Bank in London, said in a June 2 phone interview. “Then, if there is a yes vote, there would be a more directional trade to sell sterling.”
While the lead enjoyed by the unionist “Better Together” campaign has narrowed in recent months, opinion polls still point to a defeat of the nationalists seeking to end the 307-year-old U.K. The pound is at the crux of the debate, with the British government and opposition Labour Party both ruling out a formal currency union with an independent Scotland, leading to uncertainty about what legal tender the new country would adopt.
Price swings in the pound would be climbing from the lowest levels since 2007, after being suppressed by the monetary easing policies of global central banks. Three-month volatility in sterling fell to 5.09 percent on May 6, from as high as 9.42 percent in July, and is the third-lowest among 16 major currencies tracked by Bloomberg.
Deutsche Bank recommends a short position on the pound, or a bet it will weaken, with a target of $1.60, more than 4 percent lower than its level of $1.6744 as of 12:49 p.m. in London.
Sterling has climbed 10 percent against the dollar since July, reaching an almost five-year high of $1.6996 on May 6 amid speculation the U.K. would become one of the first major economies to raise interest rates since the financial crisis. The median estimate of more than 50 strategists surveyed by Bloomberg puts the pound at $1.65 by year-end.
The pound may trade at a pre-referendum discount of 0.3 percent to 1 percent, before weakening as much as 4.3 percent should Scots vote to leave the U.K., Barclays Plc analysts said in a May 27 report.
Bankers and economists are trying to gauge which financial markets best reflect the uncertainty surrounding the referendum’s outcome. The odds on a yes vote at William Hill Plc have dropped to 9-4, from 7-2 earlier this year. That means a successful 4-pound ($6.70) wager would return 9 pounds profit.
U.K. Prime Minister David Cameron sought this week to wrest back momentum from the nationalists by pledging to give Scotland control over income tax if the country sticks with the centuries-old union.
Should voters opt to leave the U.K., negotiations could get tough. As well as saying Scotland won’t be allowed to share the pound, Cameron has insisted the Bank of England wouldn’t be the lender of last resort to the Scottish financial industry, whose biggest company is Royal Bank of Scotland Group Plc, recipient of the world’s biggest banking bailout and still majority owned by British taxpayers.
Alex Salmond, Scotland’s first minister and leader of the Scottish National Party, said in February that Cameron is “bluffing,” and that an independent nation would inherit sterling and the BOE. Should the new state be denied its share of the assets, it might walk away from its liabilities, Salmond said. That would increase Britain’s debt as a proportion of gross domestic product as it loses Scotland’s 150 billion-pound economy.
“The political risk in the U.K. is a bigger deal for the currency than bonds,” Mike Amey, a fund manager at Newport Beach, California-based Pimco, told a press briefing in London on May 28. “I don’t think it’ll happen, but if it does, it will create a number of challenges. But for gilts, I don’t think it’s a big deal.”
Bond investors can shield themselves by shifting to shorter-dated securities and charging the government more to borrow over a longer period, steepening the so-called yield curve, according to Tim Worrall, a senior research fellow at the University of Edinburgh.
The extra yield that investors get from holding 30-year gilts instead of two-year notes narrowed to an almost two-year low of 2.67 percentage points on May 12, and was at 2.76 today, data compiled by Bloomberg show. That’s 1.2 percentage points more than the average over the past decade.
“It may be that the yield curve increases simply because the future becomes more uncertain and therefore you need a bigger premium to offset that future risk,” Worrall said by phone on May 21. “As we move toward the polling day, there’s actually less uncertainty because it becomes more obvious which way the way the vote’s going to go.”
Price swings in the Canadian dollar in the run-up to the 1995 referendum on Quebec secession may provide a precedent for the impact of the Scottish vote. In the year before Quebec’s vote that October, Canada’s currency traded from C$1.3274 to C$1.4272 per U.S. dollar, a gap of about 7 percent that narrowed to 4 percent in the subsequent 12 months.
Nine opinion polls since the beginning of April show the pro-union camp ahead by three to 14 percentage points, according to the U.K. Polling Report website. Kames Capital Chief Executive Officer Martin Davis, whose company is one of Edinburgh’s largest fund managers, told clients at a May 20 event in the city that the referendum could go either way.
Should Scotland opt to leave the U.K., the economic fallout and uncertainty generated may cause the BOE to postpone raising its main interest rate from a record-low 0.5 percent, according to Rob Wood, the chief U.K. economist at Berenberg Bank in London.
“It would be a bad economic event,” Wood, who until September 2012 was a BOE official, said in an interview last week. “We’ve seen over the past few years what a big spike in uncertainty can do. If negotiations drag on and they’re particularly acrimonious, you could imagine even particularly bad scenarios where you need more stimulus.”