Sterling rates show No deal complacency remains

In terms of pound capitulation, perhaps the worst is yet to come

Overview

With Boris Johnson pledging billions of pounds in public funding within weeks of becoming Britain’s Prime Minister Westminster and markets are preparing themselves for the possibility of an election sometime this year. The opposition Labour Party has made it clear it will seek to table a no-confidence vote in the government as soon as Parliament reconvenes from the summer recess, in September. At the same time, Johnson and his cabinet are adamant that they will steer the country out of the European Union by the 31^st October deadline without a deal if necessary, if Brussels continues to refuse re-negotiations of the Northern Ireland backstop.

The ensuing collapse of the pound to multi-decade lows has come in tandem with unmistakeably dovish signals from the Bank of England. If BOE policymakers act as they have suggested they will in the event of no-deal, it is striking that rate expectations are ambiguous, suggesting that the risk of a no-deal Brexit is not fully priced in.

• Overnight Index Swap rates (OIS) rates are most sanguine. The swaps are mostly used by banks to gauge and offset credit risk whilst lending to each other. At last check, implied probability of a rate cut is slightly below 60% for the Bank’s December meeting at. A 79.1% cut probability is indicated for the BOE’s June 2020 meeting. Even then, the implied probability of a 25bp rate cut for June is just 38.1%. In fact, probability of a 25bp cut of the Bank rate to 50bp at any meeting between September 2019 and June 2020 inclusive, never reaches 50% according to OIS, peaking at 44% for the December meeting, when the probability of any cut is 58.6%.
• Interpretation: OIS pricing does not appear consistent with an acceptance that Britain could crash out from the European Union without a deal on Halloween. An alternative interpretation is that even if no-deal happens, negative economic impact can be contained enough to avoid the need for a rate cut. This barely seems credible. Even the consequences of a short-term economic shot will linger. Furthermore, it is highly unlikely that the BOE would refrain from policy easing if the UK exits the EU without a deal in coming months. As such, the better interpretation is that the OIS market does not fully price a rate cut this year because it does not expect Britain to leave the EU without a deal by the end of the year.

• Sterling forward rates - contracts designed to protect the value of a cash holding over a specified period - are less optimistic. Sterling/dollar forward rates begin to fully price the probability of a BOE rate cut somewhere between policymakers' December meeting and the one scheduled for 30th January 2020 as illustrated below. After a 25bp cut either in December or in late January no further 25bp cuts are fully priced all the way till this time next year.

2019 BOE rate cut probabilities implied by GBP/USD forward rates – 13^th August 2019

Source: Bloomberg/City Index   

BOE rate cut probabilities implied by GBP/USD forward rates – 13^th August 2019

Source: Bloomberg/City Index   

• Interpretation: There are probably several different reasons for the disparity in expectations between sterling rates markets. It is certainly possible that the forward market, which probably serves corporations and non-bank institutions, is effectively more risk-averse to rate expectations than the OIS market, which generally concerns lending between banks.
• Conclusion: Either way, one important takeaway from these data is that despite the recent slump of sterling to its lowest in 34 years, pockets of 'holdouts' remain. In other words, with OIS data implying a significant part of the market is not pricing in a no-deal Brexit, the pound could yet slump to even deeper historic lows, if that event begins to look more imminent.