Analysis: U.K. Interest-Rate Volatility Is Underpricing Brexit Risk

GBP swaptions are underpricing the risk of the U.K. leaving the European Union compared with currency options, as the potential manifold impact of such an event on interest-rate markets makes it more difficult to trade, Bloomberg strategist Tanvir Sandhu writes.

The term structure of GBP swaption volatility remains upward-sloping while its foreign-exchange counterpart has inverted. The spread between implied and realized volatilities on the pound has risen to record highs while a similar measure in the rates market has lagged.

Rate volatility spreads covering June 23 referendum have diverged less from long-term averages, compared with similar currency-market measures. The differential between 10-year swaptions with two-month and one-year expiries is at 1.68, 0.6 standard deviations from its one-year average. That compares with a spread of -4.73, which is 4.6 standard deviations from its one-year mean, between the pound’s two-month and one-year implied volatilities against the dollar.

If swaption trends seen before 2014’s Scottish independence referendum are any guide, the rates market could follow its currency counterpart to turn the volatility spread negative as early as in a month.

Non-Linear Rates Impact

The impact of the referendum on the foreign-exchange market is expected to be binary, with a U.K. exit immediately sending the pound sliding, whereas the implications for rates are much less certain.

A so-called Brexit could set off opposing forces acting on the yield curve, which may have a net upward bias on long-end rates. These include the discounting of higher inflation caused by likely trade-weighted depreciation of the sterling, potential stimulus action by the Bank of England, selling of gilts by foreign investors amid increased political and credit risks and increased gilt issuance amid lower tax receipts.

Further, a possible shift lower in BOE rate-path pricing and flight-to-quality capital flows will support front-end rates while foreign investors may fear the hedging costs of currency depreciation.

Latest figures from the U.K. Debt Management Office show overseas investors hold 25.9 percent of the gilt market, which may decline somewhat if polls favor Brexit, leading to a net immediate steepening of the yield curve. MPC-dated Sonia rates currently price a 48 percent probability of a 25 basis point BOE rate cut by Dec., fueled by recent weaker soft economic data.

Current Polls

The EU referendum poll of polls published by shows the Leave and Remain vote at the same level at 50 percent. Phone-based polls continue to show a higher Remain spread versus online polls.

Opinion polls had underestimated the status-quo vote in the Scottish referendum and the last general election, where the Conservatives stayed in power.

Market-based Brexit polls remain relatively stable with the website pricing 28 percent Leave, while currently has probability of 33 percent.


Note: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for First Word. The observations he makes are his own and are not intended as investment advice.