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Brexit Gains Upper Hand in Markets

15 June 2016 by Mark Holman

With just over a week to go before the UK votes on its membership of the European Union, the financial market’s fears of a Brexit have sharply found their way into bond prices. It is safe to say that whilst the Brexit theme has been on the agenda since Mr. Cameron first announced the referendum on February 20th, the polls and betting markets had given investors a degree of comfort about the outcome. However, since the end of last week, this has changed as the Brexit message appears to have resonated well with the electorate (if the polls are to be believed) which has provided a wakeup call for those investors that may not have either considered a hedging strategy or fully implemented one.

FX markets have probably been the most efficient at pricing Brexit fears, with ‘Cable’ (£/$) being the best barometer. In bond markets we can look at both credit spreads, which will widen on the news of a Brexit, or risk free rates (such as US Treasuries and Bunds) which should decline. In the rates world, the 10 year German Bund traded below 0.00% yield for the first time in its history yesterday. One can argue about the inevitability of this, with such extraordinary ECB policies, but the dip below zero yesterday was definitely Brexit driven. In credit the Cross Over Index (a high yield index of the most frequently traded high yield names) widened out to +375 basis points yesterday, having been 50 basis points tighter last Thursday. In monetary terms this is a move of around 2 percentage points in price.

Whilst it is very difficult to predict what may happen in the aftermath of a vote to Brexit, we thought that a move of 100 basis points wider in credit spreads in the aftershock was likely. If that is correct, then we have seen a good part of the Brexit move already in bond spreads.

Similarly stock markets are down markedly in the same period, with the FTSE for example being down 6% over the same period. Another similar decline would take us back to the 2016 lows of February 11.

With the outcome of the vote so finely balanced according to the consensus of polling, it is fair to say that financial markets are now correctly pricing just how close this vote is likely to be.

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