Europe Rates Volatility Subdued as Brexit Roils FX: Analysis

As Brexit risks build to a crescendo, rates volatility in Europe remains subdued while expectations for pound swings are at multi-year highs. July bund options, which expire on the day of the U.K. referendum results, linger near year-to-date lows, Bloomberg strategist Tanvir Sandhu writes.

Implied one-month 50-delta bund volatility is at 5 percent versus year-to-date high of 7.6 percent in March. That compares with one-month EUR/GBP implied volatility at 21 percent, highest in more than six years. July option expires at 4:15 p.m. London time on June 24.

No exit poll is due on June 23 but the outcome should be known before the bund contract expires. Disparity in polling methodologies may spur volatility, as latest polls show a swing in favor of “Leave”, jolting investors who were complacent of Brexit risks.

July bund at-the-money straddle would break even at ~162.6 or 165.7. Bunds may benefit from increased Brexit risks boosting haven demand as the vote creates uncertainty about more countries clamoring to leave EU.

Rock bottom rates volatility?

The 10-year EUR interest-rate swaps gamma may rise from near year-to-date lows with diminished value in selling as the EUR curve may react to any Brexit event.

The normalized implied volatility for options expiring in a month on 10-year EUR interest-rate swaps, known as 1m10y swaptions, is an annualized 55 basis points versus a high of 72 basis points on Feb. 11. EUR swaption expiring on the same day into 10-year would break even if 10-year swap rate fixes approximately 10 basis points above or below the strike price.

Volatility catalysts in June include elections in Spain on June 26, FOMC on June 15, BOJ the next day and German Federal Constitutional Court ruling on ECB OMT program on June 21.

Implied volatility at the long-end of EUR curve is being weighed down as inflation forwards show achieving ECB’s target is a long way away, keeping distribution of expected outcomes in a narrow range.

Even though probability of deflation or very low inflation in euro-area has decreased, the pricing of high inflation outcomes could take much longer as markets question ECB’s capability to engineer a sustained pick-up in underlying inflation.

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.

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