A Bond Trader’s Rough Guide to Navigating the Brexit Endgame

(Bloomberg) -- The bond market has almost priced in success for U.K. Prime Minister Boris Johnson as he seeks Parliament’s support for his Brexit divorce agreement, with the perceived risk of a no-deal outcome dropping toward zero.

That suggests limited scope for further increases in 10-year gilt yields -- probably less than 20 basis points in the short term -- should lawmakers vote in favor of the accord. The global growth slowdown and uncertainty over the future trading relationship with the European Union should prevent a greater sell-off in the event of a ratified deal, leaving yields stuck in a higher range.

If the pact is rejected, and an election is called, yields may only see moderate declines as Johnson will likely campaign on the agreement he negotiated with the European Union rather than a no-deal prospect.

• The richness of 10-year gilts has largely corrected when modeled against the pound, euro and dollar money markets and foreign-exchange rates
• Such modeling suggests gilts would start looking cheap on a relative basis in the case of a sell-off of more than about 20 basis points, assuming the macro picture doesn’t improve
• Slowing U.K. economic activity will see the market struggle to convincingly price in a BOE rate-hiking cycle even if the deal is passed, given that the MPC will probably wait to see data turning before becoming more hawkish on the outlook
• A prolonged period of uncertainty in the case of a long extension and election creates space for the BOE to cut interest rates and would keep the front-end of the curve supported
• Money markets are pricing a 50% chance of a rate cut by next summer and the Bank Rate at around 60bps on the three-year BOE forecast horizon
• There is still plenty of premium to be removed from gilt valuations in the case of the U.K. remaining in the EU, and the pricing of any increased possibility of a second referendum is what will take yields substantially higher
• An eventual situation where investment returns to the U.K., combined with fiscal easing, would see 10-year yields hold above 1%
• Front-end U.K. inflation swaps have fallen sharply, reflecting the partial unwind of the risk of a no-deal Brexit that would result in higher inflation from a decline in sterling, food shortages and tariffs
• There is still more scope for the Brexit premium to be taken out of the inflation market if a deal is ratified or an election that results in Britain remaining in the EU

• 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, Anil Varma

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