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GRAPHIC-Brexit risk premium returns to UK markets

Mon, 14th Sep 2020 11:30

By Ritvik Carvalho

LONDON, Sept 14 (Reuters) - The latest bout of
sabre-rattling between Britain and the EU is upping the premium
investors demand for holding UK assets for fear of a chaotic
Brexit outcome with hugely damaging consequences for the
economy.

The pound is down 4% against the dollar this month. Now as
the UK parliament starts debating legislation that defies
international law by breaching the EU divorce treaty, British
shares, option markets and bonds are also swiftly pricing the
Brexit premium.

The pricing of Brexit risk is filtering through to interest
rate futures and inflation expectations too. Here are some
examples of the Brexit premium:

1) STERLING IMPLIED VOLATILITY

Implied volatility, options that show investor expectations
of future price swings in a currency, has shot up on
sterling/dollar. One-month volatility, or 'vol' in trader
parlance, is at five-month highs around 12% -- well above
implied vol on other G7 currencies.

The one-month vol spike has sent it above the 12-month
gauge, inverting the options curve for the first time since
March and implying a rise in near-term risks.

Options called risk reversals too show the implied vol
premium to buy sterling 'puts' over 'calls' has risen sharply
this month.

2) EQUITY RISK

Since Britain voted in a June 2016 referendum to exit the
EU, its stocks have underperformed. This year, the FTSE index
lags the European STOXX benchmark by 17% -- partly because the
former is heavy on poorly performing energy and commodity firms.
But Brexit is also to blame.

A sector-based comparison of performance and valuations
shows evidence of a Brexit premium.

"If you look at sector differentials -- for instance UK
energy or financials versus the rest of the world, you can see
an additional risk premium on the UK," said Justin Onuekwusi,
portfolio manager at Legal & General Investment Management.

"UK assets look cheap relative to rest of world."

3) BORROWING PREMIUM

Investors also want a Brexit premium to lend to British
companies, reflected above all in bonds issued by banks.

For instance, the gap between the yield on Barclays's
September 2023 euro-denominated bond and a Deutsche Bank note
maturing the same month has widened of late to the highest in
nearly three months around 38 basis points.

ABN Amro analysts noted that spreads on euro-denominated
bank bonds widened around 3 basis points last week, but UK
lenders saw spreads blow out by 20-30 bps.

"We anticipate that Brexit negotiations will continue to
exert negative headlines. UK risk premiums are likely to stay
elevated for the remainder of this year," they told clients.

4) CURVE STEEPENING

Brexit premia may also be contained in a steeper UK gilt
yield curve. Money markets have brought forward bets of a Bank
of England rate cut, pricing negative interest rates for
early-2021.

"If you looked at the UK curve relative to Bund curve, our
curve is now steeper. Given the currency is unable to get
cheaper and cheaper, it's easier for other things to move a
little bit. The steepening in the curve offers a premium,"
Societe Generale analyst Kit Juckes said.

4)INFLATION EXPECTATIONS

Market-based measures of future UK inflation
have ticked up, a pattern seen also after the
2016 referendum when the pound crash lifted inflation
expectations.

The latest rise in inflation expectations coincided with the
bout of pound weakness, suggesting it is Brexit-related and not
down to COVID-19 reflation, said Viraj Patel, global macro and
currency strategist at Arkera.

(Reporting by Ritvik Carvalho; additional reporting by Sujata
Rao, Thyagaraju Adinarayan and Abhinav Ramnarayan; editing by
Carmel Crimmins)

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