Someone's Stacking Bets a Hard Brexit Will Make BOE Slash Rates

(Bloomberg) --

Should a traumatic no-deal Brexit force the Bank of England to slash interest rates in the months ahead, at least one investor will be laughing.

Money-market traders have quietly accumulated more than 1 million derivative contracts that will pay off if the U.K. central bank cuts rates by 50 basis points by September next year. These are call options that grant the right to take a long position in short-sterling futures -- and after record volumes changed hands this week, the size of the holding is now more than seven times this year’s average daily turnover of such contracts.

The position was last boosted on Monday, when 323,000 calls were bought as U.K. Prime Minister Boris Johnson reiterated he won’t request an extension to the Oct. 31 Brexit deadline. The purchase was part of a so-called butterfly strategy, which involves buying options with two different target prices and selling those with a strike in the middle.

Overnight indexed swaps, commonly used to gauge rate expectations, are currently pricing in just 18 basis points of U.K. rate cuts by the end of 2020, after BOE policy makers voted unanimously to keep the benchmark rate unchanged Thursday. The central bank warned that persistent uncertainty surrounding Britain’s split with the European Union may weaken inflation.

The bet on big monetary easing comes as time runs out for the U.K. to secure a pact to ensure uninterrupted trade and business after its impending departure from the bloc. European Commission President Jean-Claude Juncker warned this week that the risk of a no-deal Brexit is now “palpable.”

Brexit Uncertainty

“I have been very surprised by the market’s lack of desire to position for BOE cuts with conviction,” said Peter Chatwell, a strategist at Mizuho International Plc. Brexit-related economic uncertainty remains high with a new U.K.-EU trade pact still distant, while a recent pound rally has tempered imported inflation risks -- these factors are boosting rate-cut odds, he said.

The buyers of short-sterling calls initially took positions in August targeting a 25-basis-point rate reduction by the BOE, after Johnson took over as leader of the U.K.’s ruling Conservative Party and vowed the nation will leave the EU in October with or without a deal.

More allocations were added later, moving the target to a half-point cut. Most of the bets expire in December -- a day before the BOE’s final meeting of the year -- while the rest mature over March, June and September 2020.

It’s the midpoint of the butterfly structure -- what traders call the body of the fly -- that shows the trade aims at large rate cuts. In Monday’s transaction, middle contracts due September 2020 were sold at implied yields more than 50 basis points below secondary-market rates.

ICE exchange data for Monday showed two butterfly trades in short-sterling futures, involving purchases of 223,000 call options expiring March 2020 and 100,000 contracts due September next year. Total call-option turnover on short-sterling futures hit a record of almost 1.5 million for the day.

The U.K. central bank’s benchmark rate is currently at 0.75%, after a 25-basis-point increase in each of the last two years. It was last lowered in August 2016 -- by 25 basis points -- in the aftermath of the Brexit referendum. The pound has slid about 6% in the past six months amid increasing investor anxiety about a no-deal Brexit.

To contact the reporter on this story: James Hirai in London at jhirai3@bloomberg.net

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

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