Brexit pricing precedents: an empirical study

As the Brexit referendum approaches, the market appears utterly incapable of taking its eyes off of the gaudy risk premiums on offer.  Indeed, having apparently blown out liquidity in the sterling options market (the one week forward one week implied volatility is currently around 33% mid), the market may have simply moved on to more liquid forms of volatility protection such as the VIX, as a few people have pointed out.

Wherever there are obscenely high implied vols, however, you can be sure that there are vol sellers lurking close by.  One of the first things that you learn as an option trader is that "high" levels of implied vol are not necessarily "expensive", just as low vols are not always cheap.   The speed with which you learn this lesson separates the quick from the dead.

In any event, the numbers are shiny: 2 week vols at 26% imply a straddle of 575 pips, and that 33% forward 1 week referenced above implies 520!  These numbers all seem very large, although perhaps slightly less so when one considers that the range of the past two weeks (when we've just been trading off of dodgy opinion polls) has been 610 pips!

What's a reasonable expectation of realized vol moving forwards relative to those levels of implieds?  Macro Man decided to comb the dusty library of his memory to examine a few other examples of (largely political) event risks to see what was priced...and what was realized.  Of course, it is impossible to know what sort of profitability could have been attained from being long (or short) options without knowing what sort of hedging would have been done, which is of course unprovable.

Nevertheless, we can still distill some insights into looking at market behaviour around key event risks and comparing it with option pricing.  Macro Man adopted the following methodology: assume that a 1 week straddle was purchased 3 business days before the event risk in question and held to maturity (2 business days after the event.)  Compare the spot range over the life of the option to the premium paid, as well as the closing price relative to the strike price.  (Note that he used the NY close rather than the 10 am NY expiry time for simplicity's sake; then again, he used the NY close 3 days before the event to set the strike price as well, so the maturity is truly 1 week.)

He looked at the following events, in chronological order:

* The Quebec independence referendum of 1995
* The French referendum on the EU constitution in 2005
* The Turkish Supreme Court decision on whether to outlaw the AKP party in 2008
* Kuroda's first big BOJ decision in 2013
* The Scottish referendum in 2014
* The UK general election of 2015

The results are set out in the summary table below:


There are a few general observations that we can make.  In each and every case, the spot range of the week straddling the event risk exceeded the straddle price, though that is hardly surprising.   It's not exactly going out on a limb to suggest that the range in cable will be greater than 520 pips between next Monday and the week after.  Were it to match the dampest of damp squibs (the Scottish referendum), that would represent a range of 675 pips or so on the week.   Matching the average range of just over 2.5 times the straddle price would represent a range of 13 big figures.

Perhaps the best case scenario for would-be option sellers is the first one on the list, the Quebec referendum.   Looking back on it, it's pretty remarkable how tame the run up was given the constitutional ramifications of the issue and the closeness of the vote (50.6% vs 49.4%).   Then again, USD/CAD was a super low-vol currency pair back then and the market was rather less developed than it is now.

There is a course a risk of a sampling error in this study.  Macro Man tried to pick events where there was either notable narrative and/or pricing heading into the event or a notable reaction afterwards.   So events that would look pretty tame in the rearview mirror such as Lula's election in 2003 didn't make the cut. 

By the same token, there are no examples in the study that have quite so much priced as the Brexit referendum.  It's perhaps notable, however, that the highest vol in the study- last year's UK general election- comfortably realized what had been priced into the implied vol market.

The ultimate issue, of course, is one of surprise and uncertainty.   The example above that perhaps best fits the current scenario is the AKP case, where the market was "hoping" for a certain outcome but far from certain that it would materialize.   There are important differences- the timing of the court decision was not on a preset schedule but known in generally rough terms- but the magnitude of the relief rally does perhaps provide a useful analogue for what might happen in the case of a "Remain" vote (looking at the rally relative to vol, not just in an absolute sense.)

While the EUR/USD sell-off after the French voted down the EU constitution comfortably exceeded what had been priced into markets, it's important to recognize that at 8% vol, nothing had been priced.

Ultimately you have to make your own decision on whether to buy or sell or not to play.   From Macro Man's perspective, given the closeness of the polls and the abject lack of liquidity he could easily see an 8 big figure move in either direction over the next couple of weeks, depending on the outcome of the vote.   Nothing that he observed in this study suggested to him that this is an outlandish view.

Obviously, if the polls shift dramatically and decisively towards remain over the next week, then the expected ex-post move will change....but then again, so will the ex-ante price.  Regardless of which way you're betting, hopefully the data above help you reach a more informed investment decision.

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rain
admin
June 14, 2016 at 8:39 AM ×

Very interesting, thanks. I think vote leave wins, markets drops into the 1.2's which then presents an excellent buying opportunity. Many a corporate would want to take advantage of that rate for $ earnings.

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Polemic
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June 14, 2016 at 8:49 AM ×

If brexit occurs there's going to be an interesting 2 year window for exporters as GBP low (assumed) and EU exit not completed. Fire sale or pump priming?

Who needs QE when you can get a bigger effect by threatening to leave a bloc? Abe/BoJ must be jealous.

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Anonymous
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June 14, 2016 at 10:07 AM ×

Pol - would Carney have to raise rates? Imagine he actually HAD to do something!

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CV
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June 14, 2016 at 10:17 AM ×

Thanks MM ...

Not doing much to be honest. I have raised some cash overall, and moved a big chunk of my cash allocation into USD via short-term USTs. But I am not betting directly on either side. I think the GBP move will be silly on Brexit, but ultimately ... it is a dip that should be bought, same with equities.

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Anonymous
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June 14, 2016 at 11:30 AM ×

@Anon 10:07
Why would he need to raise rates? If anything he may need to cut them, if reversal of capital flows leads to recession. Inflation from FX devaluation would be deemed transitory.

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washedup
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June 14, 2016 at 11:31 AM ×

@MM interesting that you think the rally in equity vol may be a spillover effect from the lack of liquidity in sterling vol. Either way, it was an epic disconnect - normally spoos would have to be down 3% for vol to have spiked the way it did yesterday. That said, in the age of risk parity, sometimes I lose the plot on what drives what, so we will see.

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June 14, 2016 at 11:57 AM ×

Agree with washedup, it's a epic disconnect...

there are some cheaper hedge around.... France/Germany 10yr at 41?

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thegitt
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June 14, 2016 at 12:10 PM ×

The only issue with this - which speaks to the illiquidity is that while compound feeds may be showing 25 for 2w GBP vol, it was actually just paid at 42.

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Macro Man
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June 14, 2016 at 12:20 PM ×

!!!!That's 934 pips if you're keeping score at home

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Error404
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June 14, 2016 at 1:04 PM ×

Excellent analysis. Tks.

EURGBP might be worth more attention than it's been getting. 'Leave' doesn't look to be priced into any EUR pair including this one (EURJPY being an arguable exception), whilst 'Remain' will send GBP daft across the board. (For a while. Until attention turns to the frothy, unbalanced economy and the EM-style twin deficits.)

The bigger question, of course, is what Wales' inevitable victory on Thursday will do to broader sentiment.

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Booger
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June 14, 2016 at 1:09 PM ×

Can't see much of a trade on Brexit currently. The spot pricing for gbp.usd is about right. The option costs are high, which is about right. If pricing gets really out of whack it might be worth a punt, but probably it will not be. If remain win, there is going to be a major unwind in the huge spec short position, so that might be worth a ride for a day or 2.

More interesting is retail sales today. I think the risk is towards a disappointment and the response would be asymmetrically bad for the USD in that case, but it runs counter to the risk off sentiment today. Sterling and Euro are unlikely to benefit as much in that case due to Brexit concerns. In that case there is a chance of an unexpected rip higher in commodities and commodity currencies if retail sales are worse than expected. Better than expected and the strong dollar trade could have it for the rest of the week.

Blooody Spoos, what a frustrating little thing. I really haven't been able to time that right all year.

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Leftback
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June 14, 2016 at 1:17 PM ×

Brexit is a fascinating sideshow to the main event of Fed/BoJ/ECB watching. All the more surreal for LB to watch as he is a citizen of that fair isle and yet the outcome of the vote will make no difference to his existence whatever, other than a cheaper pint in London (on a USD basis) and longer waits to get into the EU when on business.

The UK establishment has completely missed the boat in this campaign, btw, thinking that the issues at hand were economic ones, and failing to notice the British right wing stoking the usual fears of being over-run by a tidal wave of immigrants. Brexit campaigners will surely soon reprise Enoch Powell's "rivers of blood" speech. Farage has got it in him, of course.

To LB the temptation of a long punt on GBP seems quite strong now. We'll give it a few more days. Let's get one type of defined risk (Janet squawking about July, and we think she will do some of that tomorrow) in the rear view mirror first, and then we shall see where we are. Can't see retail sales number moving the dial much, not only one day before the Fed.

Price is News. Chart watchers may have noticed that instead of oil going up every day, it has now started to go down every day. The media narrative was relentlessly bullish at $50, but since the price retreat, the chatter has become more evenly balanced. Once the "Nigerian incidents" disappear from the narrative and are replaced by "Iran/continued supply glut" once more, the selling will pick up pace. A firmer dollar (independent of its origin) would just add fuel to the fire, of course. Oil is going below $40, perhaps quickly. USDCAD is primed for take off.

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abee crombie
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June 14, 2016 at 1:32 PM ×

I'd reload my long if oil drops below $40. Lets see. I heard some good arguments that it is in OPEC interest to keep oil volatile in order to reduce US production coming back on. Makes sense

I'm tempted to think market punters getting ahead of themselves with Brexit, with Vol being bid up across financial markets as mentioned by other. I'd like to see a strong reversal in EU bank or US Interest rates before jumping in. Kinda surprised that Japanese and EU banks just falling day in and day out. Hard for me to see big credit problems arising now without a recession, which doesnt appear to be priced into the rest of the market (industrials especially). They all have decent divy yields. And in a negative rate world you'd think at some point the market focuses on that. Not today,so I will stay away

Just getting the buy list ready in case we do have a nice sell off soon. Homebuilders? 2.5% 30 year is pretty good for me.

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Bigtail
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June 14, 2016 at 1:46 PM ×

Post Brexit yield rally Will likely trigger a New selloff wave in the European banking sector. Global domino effects lurking. The worst problem is that the markets wont be able to handle potential flows. If vol buyers run fr.o.m the Gbp/USD marker to the equity market, as described by MM, we should be very, very concerned.
Thankyou, New regulatorn and QE.

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Booger
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June 14, 2016 at 3:00 PM ×

Let's not forget the BOJ this week. Yen pairs have done well lately. I wonder if that makes at least BOJ verbal intervention likely later in the week, if not another crazy Kuroda surprise. That would be the main thing keeping me out of yen pairs until the BOJ meeting, although no one expects anything from this meeting.

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Leftback
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June 14, 2016 at 3:07 PM ×

Abee, there is no reason at all to buy EU or Japanese banks. They are losing money. The basis of all modern banking is borrowing short and lending long, and the yield curve is what makes it work. Japan and Germany have no yield at 10y.

I rest my case. Watch DB share price. Watch it every day. At some point there will have to be a rescue, but things will have to get a lot lot worse before that happens. For sure they will be forced to dilute and raise capital at some point. If DB has been a large scale vol seller, then things could get very very bad indeed. Also keep half an eye on Italian banks. One or more of them is going to go, and then we will have to see how the domino effects are managed.

Btw, you should also watch out for banks giving up their broker-dealer status and exiting the market for their own national govies (Japan and Europe), as that has the potential to wreak havoc with liquidity in even the deepest of markets.

Things are a lot more f*cked than people realize. We are not at ZIRP/NIRP in all these countries for no reason. Just as in the US in 2007-08, we are going to see Dead Banks Walking.

Boog, with Brexit risk dead ahead, all CBs are going to go out of their way to avoid precipitating extra FX vol. A big move by the BoJ would boost the dollar and Euro but that's the last thing CBs want just at the moment, one would imagine.

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罗臻
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June 14, 2016 at 3:28 PM ×

USDCNY will blow past 6.60 if Leave wins and the euro slides.

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June 14, 2016 at 3:37 PM ×

Indeed Lefty...seems there is some stress in funding, although that can always be fixed by a swap line, right? (decide for yourself)
I smile at how much ink is devoted to Brexit when in reality it is a sideshow, it is one of those triggers (if they leave) that bank sales can put in their morning pieces as why markets are selling off like crazy, when in reality dynamics have been there for the past 6-8 months. Wait until a positive outcome in the referendum, decent relief rally in risk, fed being dovish and eq market slowly bleed lower...probably weeks away. Not looking for supernovas...

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Anonymous
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June 14, 2016 at 3:47 PM ×

French OATS not happy today. WHat's up there?

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Anonymous
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June 14, 2016 at 4:14 PM ×

JBTFD & Risk Forever - what are you're thoughts from here? Genuine interest, from the other side.

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Leftback
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June 14, 2016 at 4:46 PM ×

LB didn't see this when it first appeared but it is a reasonable statement of our current trading/investment thesis. It's interesting that this guy also chose long UUP, short IWM as the basis for his summer trading, but we can promise you that we are not in fact this guy:

http://www.marketwatch.com/story/5-reasons-the-dollar-will-get-stronger-2016-05-19

With regard to the dollar, we said a while ago that the dollar can rise this summer IRRESPECTIVE OF THE FED'S ACTIONS, and that an unwind of the reflation trades would have just the same effect as a rate hike.

Draghi is now pledging to do whatever is necessary to maintain liquidity in the case of Brexit. How many bazookas can any one man keep stuffed down his pants? Even Super Mario has limits, surely?

@nonrandomwalker: Yes to swap lines. We will see them used extensively in the next few weeks, I think. LIBOR/OIS is creeping up. There are some real problems out there and someone has been swimming without their trunks on, for sure.

The oil/gold ratio had been gliding higher but that's reversed smartly in the last week or so. We doubt very much whether recent leveraged oil longs have the stomach for a nice overnight plunge, and we suspect that it isn't very far away.

Spoos have dipped below the 50 day, so that will act as resistance for the time being. Many JBTFDers and Risk Forever fans are looking forward to FOMC fellatio as usual tomorrow, but they may be disappointed. The Lady may be in no mood.

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CV
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June 14, 2016 at 6:30 PM ×

"Many JBTFDers and Risk Forever fans are looking forward to FOMC fellatio as usual tomorrow, but they may be disappointed."

Yep, that is my take too. Spoos were due a little weakness anyway. Europe, including the U.K., looks ugly all day long, but I think it is important to keep the big picture in mind here. Many U.K. equities, and I am not referring to energy and financials, were cheap going into this scare, and they could get really, really cheap if this gets silly. I have dry powder on stand-by.

As for swap-lines etc. Oh yes. Rest assured that liquidity will flow easily if Brexit happens. I think the CBs, for all the criticism they get, now know how to prevent solvent institutions from suddenly being taken out. Of course, if said institutions are INsolvent ... well ;).

For the record; I also think the ECB would cut rates if Brexit happened (QE extension already baked in here, right?). EURGBP would go to the moon. But all the action will be at the BOE. The knee-jerk reaction will be to cut ... but can Carney do it ... i.e. what happens to front-end gilts. That is the key.

A fair scenario, I think, is also that if the U.K. leaves, the EU will offer a second deal. If that is rejected ... Germany will throw its toys out of the pram.

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Cityhunter
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June 14, 2016 at 8:33 PM ×

Spot on, CV. It's confirmed by 'officials with knowledge' http://uk.reuters.com/article/uk-britain-eu-ecb-idUKKCN0Z01NQ

Love to see more and more crazy the bond market goes!

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johno
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June 14, 2016 at 8:46 PM ×

Some excellent points made here by LB concerning the European banks. When rates were positive and the yield curve steeper, there was some hope that they could repair their balance sheets with profits. But with the ECB cutting rates to negative and extending QE out the curve, the banks can't recapitalize themselves and there isn't the political will in the EU to recapitalize with state funds. Seeing banks heading for the brick wall, will markets force the issue? Can they, given the ECB's policy options/willingness to provide liquidity? Or do we have to wait for the next recession?

It seems the ECB may have corned itself. I recall Gundlach saying recently that the next major event for markets would be when the ECB and BoJ gave up the experiment of negative rates. Maybe. Perhaps a European banking crisis could force them to.

I was early taking off my GBP short Friday. I didn't want to have a position through the weekend polls, thinking they could start swinging to Remain now. Wrong.

Oil is tricky, especially with all these unplanned outages. I mean, who knows what Nigerian production is going to be three months from now? (my guess is it'll be low, since corruption greased production and Buhari is attacking it, but what do I really know?). John Dizard observed in the previous weekend's FT that a lot of oil is going into floating storage despite the flat curve. I wonder, who is taking all that outright oil exposure? If I were China and I didn't have enough onshore storage built but wanted to take advantage of low prices, wouldn't I go out and contract tankers to store oil until I was finished building them? Perhaps that explains some of it.

Interesting reversal in USTs today. Maybe just position-squaring ahead of the Fed.

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Leftback
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June 14, 2016 at 9:03 PM ×

Looks like we may get a pause in selling as we await Dame Janet and the Dots tomorrow. We took some profits in our IWM options position yesterday afternoon and we are awaiting our next opportunity. We are still short EURUSD and long USDCAD.

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abee crombie
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June 14, 2016 at 9:38 PM ×

LB, just curious on your thoughts on banks, have you taken the time to dig into any individual numbers or is everything a macro / interest rate call.

I dont pretend to be a banking expert but over the past several months the few times I have looked at individual names like Intesa or Llyods, they seemed to be very solid and I wager they will find a way to make some money, unlike say DB or CS which are iBanks and have their own issues

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Nico G
admin
June 14, 2016 at 9:46 PM ×

Intesa solid?

there is no solid accounting on which to wager anything

meanwhile in the world :

http://www.bloomberg.com/news/articles/2016-06-14/kirchner-official-caught-burying-millions-in-argentine-convent

coming across news like that is truly the worst part of our job, worse than the worst trading loss. Corruption. Greedy corporate. Greedy politicians. Everywhere. Amen

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Anonymous
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June 14, 2016 at 9:56 PM ×

Re: cable vol, the implied daily move for the 24th is north of 8%, so way more than 934 pips.

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GoingSouth
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June 14, 2016 at 10:21 PM ×

(Long time reader but first time poster here)

I'm also following UK equities with interest, and a bit of puzzlement. Many of them are essentially international companies, with most of their revenue from abroad. Therefore _in theory_ surely they should be more robust to Brexit than the currency... so when GBPUSD falls, the sterling prices of large international companies should rise to offset some of the loss.

Clearly this effect doesn't seem to be in play at the moment, as we're swept up in general uncertainty and risk off. However once the dust settles, then at some point I'd expect many UK shares to start looking very cheap to international investors. The question is at what point to switch from GBP currency (I still hold some, though I got out of most of it a week ago) to industrials, pharmaceuticals, miners, etc...

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washedup
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June 14, 2016 at 10:49 PM ×

@johno/abee - if european banks had good balance sheets and a willingness to lend, why, pray, would the ECB have to cut them out to increase credit to businesses via the corporate bond purchase program? With Loan demand static, basically BoJ and ECB are fighting their banking sectors for market share, under the assumption that if it weren't for these stodgy nitwits, EU would be a skip and a jump away from meeting their dogmatic targets.

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Anonymous
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June 14, 2016 at 11:01 PM ×

DoubleLine's Gundlach says 'central banks are losing control'

http://reut.rs/28CEnsS

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Polemic
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June 15, 2016 at 12:34 AM ×

Going South .. agree with your logic and yes, the global non UK Based, but UK listed, co.s are the first steal after any brexit panic.
Unravelling brexit moves from more worrying mkt chills is the game now. Global contagion from brexit economically is going to be light if EU stays its course. If the world does fall apart because 99% of the world's population refused to trade with 1% of the population, then I'd blame the 99%. But it won't.

re gundlach. Hardly a new theme and eminently untradable over a one year period as has been prove over the last six one year periods.

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Polemic
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June 15, 2016 at 12:36 AM ×

And as for Carney and rates on brexit? If there is a growth shock then rate cut rather than a hike in response to FX led inflation, Wrong inflation, just tell the Japaese.

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Leftback
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June 15, 2016 at 1:52 AM ×

Carney likes to do nothing and just jawbone the pound lower. If there is Brexit, he will not have to do anything.

Dame Janet wishes that she could do the same, but may be boxed in. It is possible that an unwind of reflation trades will lift the dollar and cool overheated speculation in the US without any Fed action and bail her out.

FX specialist reviews the other currency, the black liquid one that drives all inflation data, and finds it breaking down:

http://www.marctomarket.com/2016/06/great-graphic-oil-flirts-with-four.html

Pol, cable is close to its GFC 2008 lows here, one wonders if we are close to Brexit being priced in or if a much older low might be visited in the event of such a result? Like many others here we are sorely tempted to have a punt on long sterling, in the hope of the electorate eventually rejecting the more irrational and xenophobic arguments for leaving the EU. Still, as you point out, there are other drivers for USD to rally, so it might be best to sit it out and wait for the FTSE to present a raft of juicy divvy buying opportunities. We have hardly ever invested as much as 5p in the assets of our native land (due to the whole lot being inordinately over-valued, especially in USD terms) so it would be pleasing to finally own a piece of Albion.

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Leftback
admin
June 15, 2016 at 2:26 AM ×

Was anyone here actually around for the 1985 low in cable? Amusingly, that was the very moment when LB left Britain for the US, and with the exchange rate close to parity at LHR, he didn't get many greenbacks for his pounds. Luckily, LB only had £100 in his pocket and a job offer, so the event was relatively painless. Still, another drop like that to $1.10 for Betty would be bloody painful for a whole lot of punters, one assumes, not to mention triggering a nasty little (self-correcting) bout of stagflation??

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Anonymous
admin
June 15, 2016 at 2:31 AM ×

Msci says no and Yuan fixing. Oops.

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Polemic
admin
June 15, 2016 at 7:42 AM ×

That vol excess was expressing itself interestingly through the binaries last night where june 30th on touch 1.3600s in cable were at about 60% whilst Leave in bookies was at 35%. Ok, there is usd risk in there and you coukd get a ' touch n go' in the run up that looked arbable.

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Polemic
admin
June 15, 2016 at 7:50 AM ×

That vol excess was expressing itself interestingly through the binaries last night where june 30th on touch 1.3600s in cable were at about 60% whilst Leave in bookies was at 35%. Ok, there is usd risk in there and you coukd get a ' touch n go' in the run up that looked arbable.

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Eddie
admin
June 15, 2016 at 7:52 AM ×

Nico,

do you have some more color regarding Intesa? Viewed from the outside they look like the relatively cleanest dirty shirt (which is a rather low hurdle but still). How can they play the accounting game even more reckless?

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henner
admin
June 15, 2016 at 12:29 PM ×

this is from Pictet on EU banks: just passing it on. I don't know much about them

All in all, the current environment of
protracted ‘low-flation’ and the
Japanese precedent suggest caution
when it comes to European banks’
near-term prospects. There is a real
possibility that we will have low
interest rates for some time, putting
continual pressure on banks’ margins
and causing their earnings estimates
to decline even further, reinforcing
investors' concerns about
profitability. This suggests cautious
positioning in the banking sector,
avoiding most names with mid-single
digit ROEs, which may be value
traps. The more attractive banks are
the quality names or winners in their
respective areas that display aboveaverage
profitability and strong
balance sheets and that can pay out
attractive recurring dividends. Lloyds
Banking Group, BNP Paribas and
Intesa Sanpaolo might fit into this
category. At the sector level and after
a long period of underperformance
for banks which has left them trading
at low multiples relative to history,
we also believe investors should
stand ready to jump in if and when
inflation expectations shift higher.

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