‘Brexit’ Risk Absent as Futures Show BOE in Step with Fed in ’17

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If Britain is months away from quitting the European Union, the message has yet to reach one corner of the rates market.

Based on futures contracts, investors are betting the Bank of England will tighten policy at the same pace as the Federal Reserve next year. That’s wrong, says Morgan Stanley, which puts the probability of a so-called “Brexit” at more than a third.

A vote to leave the EU could force the BOE to keep interest rates at a record low for an “extended period of time” or even lower them to shore up the economy as Britain ends its 43-year membership in a 500 million-person bloc that buys almost half its exports.

“When we look across the market it doesn’t seem obvious to us the market is assigning much probability to that the U.K. might vote to exit the EU,” said Anton Heese, the London-based head of European rates strategy at Morgan Stanley.

The yield difference between the December 2016 and December 2017 short-sterling contracts and the spread for equivalent eurodollar contracts have converged this month, showing expectations that both the U.K. and U.S. central banks will tighten monetary policy at a similar pace in 2017, according to Morgan Stanley.

The gap narrowed to 1 basis point last week from 15 basis points at the start of December, when markets were pricing in more monetary tightening from the Federal Reserve than the Bank of England.

Prime Minister David Cameron has indicated he’ll hold the referendum on whether to stay in the EU in June if he can pry sufficient concessions from other members of the 28-nation club to seal a deal at a summit later this month. Much depends on whether a compromise can be struck over limiting welfare benefits to new migrants, the most contentious part of his renegotiation.

Conflicting Polls

Opinion polls have given conflicting indications of voting intentions. The latest telephone surveys by ComRes and Ipsos MORI showed leads of 18 and 19 percentage points for staying in. Three online surveys have indicated a much closer race, with aYouGov Plc poll published Monday showing 42 percent of respondents in favor of leaving compared with 38 percent for staying in the bloc.

Europe’s largest exchange, Bats Global Markets Inc., warned last week that if the U.K. withdrew, it would hurt the business climate in London and prompt the company to move some or all of its operations out of the U.K.

Subdued BOE

The outlook for U.K. interest rates remains subdued, with BOE Governor Mark Carney telling lawmakers in London on Jan. 26 that inflationary pressure remain too weak to justify ending almost seven years of emergency stimulus. Adjusted short-sterling contracts aren’t fully pricing in a quarter-point BOE rate hike until the end of next year.

Analysts at Barclays Plc, including London-based fixed income strategist Moyeen Islam, said “markets may misjudge” the impact of the referendum and are understating the likelihood of an exit. In a client note dated Jan. 28. they wrote their view “does not appear to be shared by markets, judging by pricing in FX, rates and credit.”

A chaotic exit from the EU could mean the BOE “would wait longer to tighten policy and with Bank Rate still at 0.50 percent, there is even the possibility of a rate cut,” the Barclays analysts wrote.

 

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