UK: Will FX Vol Price Action be Repeated? – Nomura
Research Team at Nomura, suggests that the market reactions to UK polls have become elevated as several polls released so far this week have shown signs that the “Vote Leave” camp has picked up momentum and the higher uncertainty has meant GBP vol has followed with them.
“So uncertainty is likely to remain elevated because the polls are telling you “we don’t know which way it will go”, but there are some lessons to learn from previous examples of UK political uncertainty.
The current market dynamic and polling moves are very reminiscent of September 2014, when Scotland looked as if it would go it alone and vote for independence. Vols spiked higher from what was a very low base (which we called The Great Moderation of 2014 at the time) and the phones rang off the hook at various polling institutions for bespoke “exit poll” poll work. These are the similarities, but the differences between that referendum and this one are larger than first implied and perhaps the market reaction may be too, but what do we know?
What we can learn from past experience?
For the Scottish referendum, polls started to say the race was becoming tighter until the week before, when the undecided voters decided to stick with the status quo. This is a pattern that is viewed quite often in referendums worldwide.
“Brexit” is arguably a much bigger event risk than that of the Scottish referendum and the UK election, and for FX vols it is equally arguable that it may be different this time. If polls continue to head further towards Brexit, then vols will likely head higher; however, if this does not occur, a the potential for a further increase in the event vol add-on into the referendum is likely smaller in magnitude than its potential to fall.
Short-term breakdown in negative relationship between GBP spot and volatility is possible in the run-up
We also look at the correlations between GBP spot and vol. Looking at episodes of previous political uncertainty, the correlation between spot GBP and its implied volatility tends to be negative. This correlation is likely to remain negative into the referendum.
Polls showing a swing towards “Remain” could see GBP rally and vol sell off, while polls getting tighter could lead to a GBP sell off and vol rise over increased uncertainty.
We believe that the only possible material breakdown of this relationship going into the referendum is if the opinion polls switched to show “Remain” with a lead sufficient to remove the risk of Brexit from market pricing (which we view as unlikely).
However, short-term divergence from this inverse relationship is possible (as we have seen this week). Market risk sentiment remains a key driver of GBP, as well as Brexit risk. Therefore, in the short term, GBP can perform under a positive risk environment, even when vol is increasing amid higher Brexit risk.”