Brexit Talks Bring Ray of Light to Deluded U.K. Inflation Market

(Bloomberg) -- Brexit risks have distorted the outlook for U.K. inflation ever since the 2016 Brexit referendum. The market may be about to discover by exactly how much.

Betting on lower inflation expectations has been a painful trade for investors in recent years. The persistent high level, given a no-deal exit from the European Union would lead to a pound slump and a spike in prices, appears in contrast to the U.K.’s sagging economy.

Now, optimism in recent days for a Brexit agreement means short positions are finally starting to work out. There remains a long way to go for those bets, depending on whether a Brexit deal can be achieved.

• A Brexit deal or no Brexit will see a full unwind of the net short currency positioning (which may see the pound rally by more than 5%), reducing the risk of higher inflation from food shortages and tariffs, to the benefit of short inflation positions
• The Brexit premium in U.K. fixed-income markets is by far the highest in inflation breakevens, which have remained elevated since 2016 despite the impact from the fall in the pound having passed through
• Annual CPI in September held at 1.7% in data Wednesday, below the Bank of England’s 2% target, and realized inflation should stay below that with underlying price pressures not showing any upward momentum
• The richness of 5y5y inflation swaps at 3.6% is well above actual realized inflation, even allowing for some additional risk premium
• Shorting elevated inflation markets on the currency pass-through effect has faced large liquidity risk associated with no-deal, preventing an aggressive outright fade
• Buying floor options, a bet on inflation falling below a certain threshold, probably provides a better risk-reward profile against stubbornly high inflation swaps and the threat of a no-deal
• The latest Brexit optimism has seen the front-end of the RPI curve, which has been underpinned by import-tariff risks and supply-side weakness, fall more than 20 basis points over the week and 5y5y RPI swaps fall 11 basis points, in line with the rally in sterling
• But the declines have halted as markets remain hostage to headline noise and await a clean signal on Brexit

• NOTE: Tanvir Sandhu is a global fixed income and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

To contact the reporter on this story: Tanvir Sandhu in London at tsandhu17@bloomberg.net

To contact the editors responsible for this story: Paul Dobson at pdobson2@bloomberg.net, Neil Chatterjee, William Shaw

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