FxWirePro: Brexit bonkers fade away, BoE stays pat, hedge tailwinds in FTSE and EUR/GBP in 2018

The monetary policy committee voted to leave interest rates on hold at 0.5% in a unanimous decision.

The BoE also maintained its current quantitative easing stimulus program, which has bought £435 billion of government debt and £10 billion of corporate bonds.

The outlook for UK equities in 2018 is likely to be increasingly shaped through the Brexit lens. So far in 2017, we note that the FTSE100 is the worst-performing index among the most widely used global equity benchmarks year-to-date, despite the backdrop of positive growth revisions. 

Comparing volatility across different UK assets yields an interesting view of how different asset classes have been behaving.

Firstly, the current dispersion in equity, rates and FX volatility levels seems elevated by historical standards.

More specifically, FX volatility has remained at around average levels over the last five years while rates volatility is currently more than two standard deviations below average levels. Equity volatility is at around one standard deviation below average levels.

Secondly, this dispersion seems to validate our view back in June that FX will bear the brunt of Brexit, while equity volatility will remain subdued in sympathy with other equity indices globally.

Sterling gained a bit against the euro soon after BoE’s unchanged monetary policy but continued losing streaks 3 days in a row, with EURGBP last at 0.8811, off an earlier low of 0.8780.

Hedging a growth shock in the UK:  Add longs in FTSE100 Dec18, 97% put conditional on EURGBP above 0.92 for 1.35% premium (ref: 7481 and 0.8780, c.75% discount to vanilla)

While market expectations of a softer Brexit have increased recently, it is expected that the growth to be significantly lower (0.6pp) than consensus in 2018. Investors who believe that the risks of a growth shock are higher than what is being priced by consensus can hedge this risk by buying downside protection on the FTSE100 index conditional on EURGBP above 0.92 at expiry.

The base case is for the EUR to gradually strengthen against the GBP. Moreover, it is also conceivable that in the case that growth surprises on the downside, further easing from the BoE would start to be priced in, taking EURGBP even higher. We reckon that the risk premium would begin to build up in risk assets in the UK in this case, and in that scenario, it may be tough for even the internationally oriented FTSE100 large caps to remain unaffected. A 1y 97% strike put on the FTSE contingent on EURGBP above 0.92 costs 1%. The current positive correlation reduces the vanilla put premium by 75%. 

Risk: only the premium paid up front is at risk if the FTSE100 ends up above the strike at expiry and if EURGBP is below 0.92 at expiry.