Quantifying the Brexit premium and the Walking Dead, Season 8

Before addressing today's FOMC meeting Macro Man wanted to briefly return to the Brexit issue because it really is so very interesting.  One thing that he can not stress enough is the ephemeral nature of market pricing.  Yesterday's post cited 2 week vols of 26%, which is what Macro Man pulled from his Reuters feed.   Yet Tuesday morning they were getting paid at 42!

According to one of Macro Man's mates in the market (who occasionally comments here), yesterday morning the implied overnight vol for the 23rd/24th was 140%, which translates to roughly 6%, or 830 pips.   Yet by the end of the day another reader was claiming that the overnight was now priced at 8%, which represents an implied vol level of 190%.   Needless to say, these types of volatilities are essentially unprecedented in foreign exchange, perhaps excepting long-distant crisis events such as USD/IDR in 1997 or DEM/ITL in 1992 or 1995.

In any event, sterling vols are now firmly in Rolls Royce territory: if you have to ask the price, you probably cannot afford it.  Macro Man thought it might be interesting to try and tease out some data on the market impact of swings in Brexit expectations.   His first port of call was to use some sort of control model; he looked at the 2y2y spread between US and UK rates (chosen to fall largely outside of a putative Brexit) as an explanatory variable for cable, using 2014-15 as an in sample period.  Gratifyingly, he found a generally good fit, but with cable trading substantially lower than the model would suggest over the past nine months.   There is our Brexit premium!

(Note that the usual caveats apply: the regression was run on levels rather than changes given the noisiness of high frequency data, etc.)

His mate then sent him the Brexit betting odds helpfully stored on the Bloomberg terminal.  Running the model for this year obviously generates a much better fit; importantly, though, recent changes in the model have echoed the move in spot the way that a simple rates model does not capture.  Interestingly, the new model is now at its most bearish on cable- unsurprising, really, given where the betting odds are!

The model stats are set out below.  As you can see, in 2014-15 a 100 bp relative shift in 2y2y swap rates in the UK and US was worth more than 21 big figures; this year, it's worth slightly less than 10.   The real interesting bit is the beta of the Brexit odds: 0.264.  The implication, therefore, is that given how the market has traded off of betting odds, the ultimate difference in cable based on whether Remain or Leave win is 26.4 big figures.   Given the current odds of 43.3%, the upshot is that rate spreads being equal, cable will sell of 15 big figures on a Brexit vote (call it 1.25 or so) and rally over 11 figures on a Remain vote (1.52-ish).  In a world where we don't know if the implied overnight is worth 140 or 190 or 220 vols, these numbers really don't seem too far out of whack.  With the sensitivity of cable to swings in polls and expectation, it sure feels like there's some value in owning gamma that expires even before the vote, given the illiquidity in spot and gappy price action.   Good luck finding a friendly vendor at a reasonable price, however....

As for the Fed, yesterday's fixed income price action felt more than a little climactic, helped partially by Bunds having a decent go at rejecting negative yields.   The candle on the 10y yield chart certainly looks like a reversal pattern, which would jive nicely with the Fed grasping the wheel of the monetary bus and speaking calmly and confidently over the intercom.

While there's always a source of worry (how can there not be, when one of your self-appointed decision criteria is "global conditions"?), despite the recent payroll number the economy is tracking along very nicely in Q2, thank you very much.  Yesterday's retail sales figure was solid, with the retail control figure positing its highest 3m/3m change in nearly two years.

Of course, over the last few years it's taken five pieces of good news to counterbalance one piece of bad, and the payroll figure was clearly pretty bad.   That being said, recent Fed communication has done little to suggest anything but a general (though not universal) desire to adjust rates upwards before too long.

Now, it's clear to everyone that the only two hopes of a rate hike today are Bob Hope and No Hope, so clearly attention will be paid to the forward looking message from the statement, the SEP, and the press conference.   Given the extremes in market pricing (driven both by Brexit fears and the black hole of yield located in Frankfurt), now might be an apt time to gently lean against market pricing (or at least, expectation) so as to keep the committee's options open.

Macro Man was amused and bemused to see another piece from Larry Summers trotting out the usual OH NOES, NOT RATE HIKES! trope.  Macro Man had to chuckle at the threat that in hiking rates, the Fed could push the US into the same boat as the EU and Japan, both of whom have taken rates negative and seen their banking sectors eviscerated as a result.

There remains no empirical example of a large heterogeneous economy escaping extreme disinflation through zombification, crushing the cost of (and return on) capital, and encouraging investment into low-return pursuits that hamper productivity.  There remain numerous examples of these policies failing to achieve the inflaton goal.  The Walking Dead gets great ratings from academics but it sucks to live within the narrative.

Macro Man feels compelled to trot out one of his favourite charts which summarizes the current situation to a T.  Simply put, the data would suggest that the dearth of inflation in the US can be explained simply by a prior rapid expansion in the country's industrial capacity, with the level of that capacity well above trend and utilization rates well below historic norms.  Can we really expect a secular uptick in inflation with so much excess capacity?

All of this will get you a cup of coffee and little else, however.   What matters is what the Fed will say and do.  For choice, Macro Man does expect them to acknowledge the risks posed by Brexit and elsewhere as a primary short-term focus.  Ultimately, however, he looks for them to say with that caveat, if things go smoothly and the economy performs as expected (ie, continues tracking 2.5% + and the labor data snaps back) then the door remains wide open for another rate move before long.

Whether markets like that may well be irrelevant in the short term, with option expiry, the looming vote, and a scramble for vol and safety likely to dominate in the coming days.