The crunch Brexit summit managed to produce a six-month delay until the end of October, a compromise between French President Macron’s hard line and the remainder of the EU 27’s position. Supposedly, the UK can leave at any time in the interim if a deal is struck in the interim. The delay was greeted with no volatility in sterling, and implied volatilities for sterling continue to collapse as we discuss with the chart below.
I believe the risks lean to the downside for sterling in this scenario. Even if May and Corbyn are able to cobble together a compromise deal based on the UK staying within the EU customs union, the risk remains that this deal would require a referendum for approval, and any referendum presents significant risk that we end with a No Deal. The one issue providing considerable time pressure on the UK is the EU Parliament time schedule in late May, which will require that the UK participates if nothing is decided well ahead of the date. Chart: EURGBP volatility
out the chart below as an indication of the degree to which anticipation of GBP volatility has collapsed recently, a phenomenon that has only deepened this week. While it is quite understandable that 3-month implied volatilities begin to price the uncertainty of a further long delay out over the horizon, it is interesting to note that 1-year volatilities (the red line in the chart below) have collapsed in almost equal measure. The pink dotted line shows that low-delta 1-year EURGBP calls still demand a premium to puts, but a shrinking one.
The European Central Bank meeting yesterday saw a very downbeat President Draghi, but he failed to flesh out TLTRO details and any decision on “tiered” rates to prevent the ECB from punishing banks with negative rates held at the central bank. It appears the ECB wants to buy a bit more time for a sense of the trajectory of the economy before providing more details in June with the next round of projections.
Some are arguing that market is even shifting expectations in favour of rate cuts, but that looks a stretch. The ECB is at the end of it policy mandate and could only reach for new, more powerful tools in a dire emergency. It is clear that from here, the next key steps will have to be taken at the fiscal level, on how to deleverage peripheral sovereigns that will never grow their way into paying back their excessive debt loads.
Either restructuring or devaluation of the debt via inflation are required – and both of these options would require a major policy initiative from the EU executive, as the ECB can do neither of these. See the latest Ambrose Evans Pritchard piece
at the Telegraph reminding us of the debt dynamics for Italy, for example. Next on the EU calendar, now that Brexit has earned a long delay, are the EU parliamentary elections – which may produce a significantly larger, if still fractured between leftist and rightist factions, Eurosceptic minority.