One Trader's 4-Step Process For Figuring Out Brexit: Project Fear Vs Relief Rally

With traders’ expectations for sterling volatility remaining anxiety-inducingly high…

And cable unable to rebound from yesterday’s drop, amid a new onslaught of establishment fearmongery…

Bloomberg’s Macro Strategist Mark Cudmore has an answer (or a process) to the multi-billion pound question everyone is asking: what’s priced in for sterling and where’s the next big move?

Don’t try to answer. Instead, think of a framework for assessing the situation.

1. Make things as simple as possible

There are multiple scenarios but they can essentially be divided into a binary decision of either

  • Chaos: a hard Brexit or no-deal Brexit starting next March (or at least that result looking likely until near the March deadline); or…

  • Relief: no major change of economic status quo, either because the current Brexit deal passes, Brexit is cancelled via a second referendum, or the negotiation period is extended

2. Set a baseline

Estimate where we were at Wednesday’s close — when an agreement was in place and the Cabinet had signed off, and before any ministers had resigned. Let’s say we were pricing 50% chaos / 50% relief then.

Next, estimate how those probabilities had shifted by Thursday’s close. It looks more fraught, but not blind panic. Say 65% chaos / 35% relief.

The Bloomberg British Pound Index fell by ~2% in that period. So, based on the input probabilities, that indicates that a 15% shift toward the chaos scenario caused a 2% reaction in sterling.

But bear in mind the gyrations may be bigger, the closer we get toward 100% likelihood of one outcome or the other.

3a. Identify the next major event risks.

PM Theresa May has given no indication that she will resign, so the next major catalyst could be a confidence vote on her leadership.

Until a confidence vote is declared, sterling should slowly grind higher as the gap between the probabilities narrows.

If a confidence vote is declared, it may shift the probabilities again — to, say, a 75% chance of our chaos outcome — within just a couple of hours. A 10% probability move (rather than the earlier 15% probability shift), but at a higher-beta part of the curve, may lead traders to expect something like another ~2% drop in the Pound Index.

3b. Break those risks into a decision tree

If May loses the confidence vote, we get closer to a chaos outcome (maybe 85%), which could trigger another negative reaction in the Pound Index, again larger relative to the change in probabilities as we’re still further along the curve. Sterling could be another 2.5% weaker and still falling, though with the risk of occasional rallies on any headlines that change the narrative

If May wins the confidence vote, the relief scenario gains a bit of ground (back to, say, 40%), so the pound should strengthen. And by the time of the parliamentary vote, there’s a chance the equation could be more like 55% chaos / 45% relief as May works with a tailwind to campaign for the deal. That’s 10% better than we are now, so the pound could probably be ~1.5% higher than we currently trade

4. Weigh everything up and wait for the opportunity

Having assigned a probability that there’ll be a confidence vote, and then also whether May survives such a vote, then it’s possible to probability-weight the likelihood of where sterling will trade under the various outcomes. When it looks misaligned versus expectations of how the drama plays out — that’s the moment to pounce.

This process can obviously be extended to the parliamentary vote and all the other major steps on the way.

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