Adventures in Brexit Wasteland Leave U.K. Bond Markets Nowhere

(Bloomberg) -- Speculators in U.K. bonds will need to see how long a Brexit extension the European Union grants, to work out which way to go. A short delay should see yields move higher but prolonged uncertainty will push them lower.

There is little doubt the EU will allow Britain to defer Thursday’s Halloween deadline. Anything shorter than the U.K.’s request for Jan. 31 may pressure Parliament to ratify the Brexit deal bill, spurring a limited move higher of around 15 basis points in 10-year yields to 0.80% or so. A longer delay will just continue to hurt growth and may push yields down to around 0.50%.

In the absence of a magical solution to Brexit, yields will remain trapped. That means traders need to be nimble within this range, while also looking at the tail risk options for large potential payoffs.

• The risk-reward of trading gilts is far from convincing given the range of scenarios is wide and unpredictable, which favors playing the wings
• In the short-term, while a longer extension and general election prolongs uncertainty, the downside move in yields on the back of that would be limited to around 0.50% given no-deal risk has evaporated for now
• The upper end of the range is defined by gilts looking cheap on a relative basis in the case of a selloff that takes yields up by more than about 15 basis points (assuming the macro picture doesn’t improve)
• One potential options strategy could be to fade the richness of the receiver skew to fund payers, combined with call options on short sterling to hedge the risk of BOE rate cuts
• Politics is far from predictable and deep out-the-money options on other tail risks should be considered: a Corbyn-led government and remaining in the EU
• But the path getting there will be twisted as extended uncertainty risks seeing the BOE cut rates to support growth; a cleaner payoff could be wing structures on FTSE 250 stocks on Corbyn or remain

• 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

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