UK Yields, Cable Rise As Brexit Fears Fade; Is Move Overdone? - Analysts

UK Yields, Cable Rise As Brexit Fears Fade; Is Move Overdone? - Analysts

27 April 2016, 12:27
Vasilii Apostolidi

UK Gilt yields and sterling have romped higher in recent sessions, as fears about the UK leaving the European Union have faded.

Analysts warned however, that just as Brexit jitters may have been overdone to the downside earlier in the year, the current euphoria may not be long lasting either.

"Sterling has rallied against both the dollar and the euro over the last week on the assumption that interventions by the UK Treasury and (U.S.) President (Barack) Obama in the Brexit debate have shifted public opinion towards remaining in the E.U.," said Samuel Tombs, chief UK economist at Pantheon Macroeconomics.


Betting markets currently were pricing in a 25% chance of Brexit, versus 35% odds a week ago, he observed.

But, this does not necessarily mean that voting intentions have changed to the same degree, Tombs said.

"We do not rule out future polls supporting the markets' view that Brexit risks have faded, but this news seems to be fully priced-in," he said.

"The risks of a renewed depreciation of sterling over the next week or two therefore are greater than a further appreciation," Tombs said.

Looking out further, Pantheon saw the risk of Brexit at "about one-in-three, and we expect the pound's rally to unwind, perhaps with sterling falling to $1.38 and E1.25" heading into the June 23 vote as market players "reassess the risks," he said.

If support for the Remain camp continues to build, then cable could rebound further.

"We think sterling could end the year at about $1.4200 and E1.35," Tombs said.

JP Morgan strategists said the UK Treasury's "extensive analysis of the economic consequences of Brexit and President Obama's intervention" has shifted sentiment, with "the betting markets in favor of a Remain vote - the average odds on Brexit have declined from 33% at the start of last week to 24% today."

However, JPM's model, an "estimated fair-value from a 7Y regression model based on 2Y rate differentials and CB balance sheets where the R2 is 75% and SE is 3 cents," saw the risk premium in cable as being "completely eliminated at $1.4530."

The strategists warned that "owning cable is no longer an attractive proposition for participants looking to fade Brexit risk."

They maintained that in light of current UK fundamentals, hinting at a softer economy, cable may not be able to return to the low to mid $1.50 levels seen in late 2015.

JP Morgan planned to keep a close eye on preliminary first quarter GDP data, due out Wednesday. MNI's median is +0.4% quarter-on-quarter and +2.0% year-on-year.

Looking at the options market for sterling, Brown Brothers Harriman analysts noted that "investors need to be careful extrapolating too much from the decline in the benchmark three-month volatility and call-put skew."

"Three-month optionality goes well beyond the referendum, which has now moved within the two-month window," with all the pressure "squeezed into two-month duration," they said.

Two-month sterling volatility hit new six-year highs of more than 14.5% earlier, "surpassing three-month volatility, which has fallen below 13%," the analysts said.

In the same vein, "the call-put skew (25 delta risk-reversal) is being reduced in the three-month options," where the premium for sterling puts over calls is currently around 3.68%, versus 4.45% at the end of last week, they said

In contrast, "the two-month skew favors sterling puts by 3.8% compared with 1.22% before the weekend," Brown Brothers said.

Receding Brexit fears have underpinned UK Gilt yields and cable.

Ten-year Gilts were last at 1.660%, down from an earlier high of 1.67%, which was the highest level seen since late January.

The 200-day moving average comes in at 1.74% and will act as larger resistance.

With interest rate differentials narrowing and now less in the U.S. favor, cable has been on the rise.

Sterling, trading at 1.4577 Tuesday, topped out earlier at $1.4639, the highest level since Feb. 4, when the pair peaked at $1.4668.

After closing near $1.4736 on Dec. 31, 2015, cable was weighed at the start of the year not only by rising Brexit jitters but also by rising risk aversion as the market reacted to uncertainty about China's currency and economy and a host of other issues earlier in 2016.

Sterling posted a 2016 low near $1.3836 on Feb. 29, low levels last seen in March 2009, the month the S&P 500 hit the post-crisis low of 666.79.

The 2015 high for cable was $1.5930, seen June 18, seen about a month after the S&P 500 posted a new life-time high of 2,134.72 on May 20.

While cable has managed to vault its 55-day moving average, currently at $1.4251, the pair may struggle to break above its 200-day moving average, currently at $1.4889, let alone the psychological $1.5000 mark.

Sterling has traded below its 200-day moving average since early November.

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