Market still sees hard Brexit

Sterling markets believe the UK is heading toward a hard Brexit in two years’ time and are preparing for a volatile period over the next few months.

Yesterday marked three months until a key European leaders’ meeting that could shape the final divorce. That means benchmark three-month sterling volatility will start to cover the October 19-20 summit for the first time.

Traders need to gauge how a German election, three months of talks, and political feuds in the UK will change the Brexit outlook by then.

“The market is leaning toward a firm no deal and a hard Brexit fallout scenario,” said Neil Jones, the head of hedge fund sales at Mizuho Bank in London, adding that a change of mood before the summit would benefit those going long on volatility.

Three-month implied volatility, a measure of pound price swings based on options, has declined this year to about 7.8%, a far cry from the 18.5% reached on June 14 last year, days before the EU referendum. Given market positioning, Mr Jones said that if the talks lead to a shift toward a smoother split or closer trading ties, it could shoot through 10% and trade at 15%.

“On a soft Brexit I sense it will move back to flat, which is sizeable,” Mr Jones said.

The market will also factor in risk events such as two Bank of England policy meets and Germany’s federal elections in September. Polls suggest Chancellor Angela Merkel will win a fourth term but the make-up of her coalition, and what stance it could take on Brexit, remains unclear.

The UK’s inconclusive election last month has spurred talk of a more conciliatory approach by UK Prime Minister Theresa May. The UK acknowledged last week for the first time in writing that it will have to pay money to leave the EU, one of the thorniest issues in the talks.

Ms May, meanwhile, will face her own set of domestic challenges that could swing the pound.

After a summer recess ending September 5, the UK parliament will debate her bill to transpose all existing EU legislation into UK law. When it was introduced to the House of Commons on July 13, it sparked a backlash from opposition parties including Labour and the Liberal Democrats, who said they would seek to amend it.

She’s likely to have even greater difficulties in the House of Lords.

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