Traders appear less worried about crunch Brexit talks than in the past, and are positioning for an amicable outcome between the United Kingdom and the European Union.
Falling breakeven rates, cheaper gilts and a rebound in the pound against the euro all reflect market optimism that — despite recent bluster — the two sides will clinch a deal at the eleventh hour, as has often been the case since the UK voted to leave in the 2016 referendum.
The parties are embroiled in a week of discussions, with the bloc stiffening its demands over how any trade deal will be enforced. The turnaround in market sentiment is a surprise given that expectations about a deal were low after the introduction of the Internal Market Bill on Sept. 9.
The UK’s five- and 10-year inflation breakeven rates have fallen in the past couple of weeks after climbing to the highest in almost a year when the government put forward the Internal Market Bill, sparking concern that its introduction may stymie a trade deal. If talks break down, the pound is likely to decline, which will show up as faster inflation. In other words, the drop in breakeven rates in the past two weeks shows traders may be scaling down their positioning on a failure of the talks.
The inflation market has historically been savvy in foreseeing outcomes. Breakeven rates collapsed in November last year ahead of the UK elections by unwinding a risk premium and focusing on currency strength that would flow from a victory by the Conservative party.
Gilts hold poise
The front end of the UK’s yield curve has also retained its composure. Gilt yields have, in fact, climbed in the past two weeks despite the introduction of the Internal Market Bill in the UK parliament. What’s more, the increase has come about despite the Bank of England saying earlier this month that it had received a briefing on negative rates.
A cheapening of front-end gilts suggests expectation that a deal will eventually be clinched. Meanwhile, three-month options on two-year swaps are now being quoted around 28 basis points, well below the 40-basis point average of the past five years. At current levels, the swaptions market is factoring in a daily move of about 1.76 basis points, which is more or less aligned with historical volatility on the tenor.
Muted currency swings
The euro’s volatility quoted against sterling provides another read-out of sentiment. Implied volatility in the pair, while elevated, is dwarfed by peaks seen since the exit vote. Meanwhile, the euro’s spot rate against the pound has weakened about 1.5% in the past week, surrendering about half the gains made when Downing Street introduced the Internal Market Bill.
While the euro is still trading above its modelled fair value of 0.8878 pounds, the margin of premium has shrunk in the past fortnight, another tell-tale indicator that the market isn’t losing sleep on the shape of trade in the post-transition period.