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The outcome of the UK 23 June referendum remains uncertain – so there is value in conditional trades expressing Bremain or Brexit scenarios. If UK voters decide to remain in the EU, the GBP front end and belly will reprice higher, as the market scales down BoE rate cut fears.
Several surveys in the run-up to the referendum showed companies deferring investment decisions until the outcome was known. The UK economy has effectively been on pause, underlined by data showing first-quarter GDP and the UK current account deficit were much worse than expected.
So, the FI (fixed income) outlook H2 2016, looking at how the segmented forward curve has performed since the start of 2016, it is clear that it is the 4-5Y area of the curve that remains the most vulnerable.
Finance GBP payer spreads by selling EUR payers:
The potential for GBP rates to increase in case of Bremain remains limited because of persisting uncertainty over UK growth and limited scope for monetary tightening.
The global grab for yield could also disproportionately benefit gilts, after significant outflows YTD. At the same time, downside risks to the medium-term inflation outlook will keep the ECB prudent, anchoring the EUR belly. This suggests financing GBP 5y tail payer spreads by selling EUR payers.
EUR mid-curve payers in the belly are an attractive sell because of higher vol compared to vanillas, and because of strong rates rolldown.
