Last week, Theresa May managed to secure yet another extension to the UK’s Brexit deadline – flexible in nature, the new deadline will be 31st October 2019.
With many EU leaders favouring a much longer extension, the emergency meeting in Brussels took over 6 hours to come to its decision; French President Macron took a tougher stance, pushing for a shorter deadline so it seems that 6 months is much of a compromise. European Council President, Donald Tusk also issuing a stark warning to the UK, not to waste any time in reaching a deal. To be fair, UK has had a poor record of taking heed to these types of warnings.
This does mean that should British MPs not pass a withdrawal agreement by 22nd May, the UK will have to participate in European parliamentary elections in May (23rd-26th) or risk leaving the EU on 1st June without a deal.
On balance, it would appear this result is good for investors and financial markets – for one, the risk of leaving with “no deal” or worse still “no deal by accident” seems mitigated. Furthermore, the chance of a second referendum and a cancelling of the Brexit project altogether have also possibly increased.
However, Eurosceptics are extremely agitated, understandable given that the Prime Minister has in the past few weeks shifted from “my deal or no deal” to “my deal or long delay (with EU elections attached)” – somewhat showing her biased hand.
How have markets reacted?
At first glance, it appears that the general public’s Brexit fatigue has spilled over to financial markets – the table below illustrates markets reaction since Wednesday’s extension announcement.
The lack of reaction partly reflect the fact that investors are still none the wiser on how to quantify the political risks nor are they able to estimate the economic effects.
On the latter, the BoE are still poised to keep rates on hold, despite the UK modestly beating expectations by growing at 0.3% in the three months to February, albeit aided by UK firms stockpiling. So, it appears that the 6-month delay is far too short for the BoE to need to make any firm decisions and hence capping any upside euphoria in GBP.
Interestingly, whilst spot reaction was fairly muted, there was a very sharp move lover in GBP vols – as illustrated in the chart below, 3Y vol has fallen over 30% since the start of the year. This phenomena has been witnessed across the different tenors, with the short-term tenors falling most acutely. To put the vol move in perspective, vol collapsed with a 7 standard deviation sell-off in the 3 month tenor.
It is worth noting that that whilst the pace of the fall in vols has been exceptionally aggressive, in absolute terms, it brings vols levels back close to levels pre referendum – roughly back in line with where other currency vols are trading (i.e. reducing the Brexit premia).
Nonetheless, while Sterling markets might look a sea of calm at present, undercurrents to rougher waters may lie beneath the surface.
Conservative Party rules say there cannot be another no confidence vote in May’s party leadership until December, however the ever-frustrated leaders of the Conservative backbenchers (the so-called 1922 committee) are constantly plotting to try to persuade May to quit sooner. Should that not work, a bad local election on 2nd May or bad European elections on 23rd May may be prove too much for her to remain at the helm.
Hence, though ‘no deal‘ cliff-edge risks have been delayed or mitigated (at best), they have been swapped for domestic political cliff-edge risks in the form of leadership changes or snap elections.
On balance and from a risk perspective, prudent investors should be looking to take advantage of suppressed vol levels to mitigate any new or existing GBP FX or liquidity risks or simply to hedge against a larger macro event.
Author: James Sebastian