While investors have clearly interpreted the process of the U.K. leaving the European Union as negative for the pound sterling and domestic stocks, the range of potential outcomes has made it far harder to position in the sovereign debt market.
But unlike Italy's budget wrangling with the European Commission in recent weeks, which has trained most investor focus on bond yields, Brexit has put the currency market at the center of attention for investors reacting to political noise.
The fallout of Prime Minister Theresa May's proposed agreement with the EU included a slew of resignations from her government Nov. 15, and members of the ruling conservative party are in open rebellion, actively seeking the 48 signatures required to spark a leadership contest. The embattled May is poised to propose the EU withdrawal agreement bill to parliament in early December despite it appearing almost impossible that a majority will back the deal.
The currency markets reacted to this added uncertainty as expected, with the pound slipping from €1.15 to below €1.13 on Nov. 15. A sharp movement, but still leaving the pound stronger against the euro than at the end of October, as currency volatility has become the norm.
'Difficult to read'
The direction of travel on U.K. bonds has been much less clear throughout the Brexit process, although on Nov. 15, some market consensus appeared to have been reached as yields on 10-year gilts fell by 13 basis points amid the resignations. But that yield rebounded by 5 basis points in Nov. 16 trading as the implications for interest rates, and the potential for a further round of quantitative easing, cloud the outlook.
"Brexit is untradeable in the gilts market," said Heinz Gunasekera, director of European rates trading at Barclays. "People find it difficult to read so most people are taking risk in the foreign-exchange market."
Having sunk from 1.49% on the June 23, 2016, referendum to a low of 0.54% in the immediate aftermath of the result, yields on 10-year gilts have been largely range-bound between 1.2% and 1.5% for the past year amid the Brexit negotiations between the U.K. and the EU.
The gilt is often used as a flight-to-quality asset in times of market stress, and that has restrained the yield even as the value of the currency tumbles at every indication that a deal may not be secured. But that safe-haven status may be lost as the Brexit process continues.
"The situation remains highly uncertain and betting on the outcome is currently a bit of a lottery. Either way, the U.K.’s reputation as a bastion of stability has been tarnished," wrote Robert Lea, head of global equity research at Ashburton Investments, in a Nov. 15 note.
No-deal scenario planning
Asset managers such as Vanguard are recommending investors diversify their portfolios across global markets, with group economist Shaan Raithatha saying, "the truth is we just don't know how it will pan out."
Barclays has calculated that a no-deal scenario, in which the U.K. leaves the EU in March 2019 without a formal agreement, would see inflation jump to 3.5% assuming depreciation in the currency and the establishment of World Trade Organization tariffs. The Bank of England has hinted at further rate hikes should the economy continue to grow in line with its base case expectations. But Barclays suggests the central bank will instead cut rates to stimulate the economy in a no-deal scenario, as growth would slow to zero and risk a recession.
Should a transitional deal clear parliament, Mike Amey, head of sterling portfolio management at PIMCO, expects yields on gilts to rise. "With the U.K. economy at full capacity and some signs of wages rising, a deal also increases the likelihood of the [Bank of England] raising interest rates more than is currently priced in by markets," he wrote in a recent note, suggesting expectations of two rate rises over the next two years.
A no-deal scenario has led to renewed talk of the pound falling to parity with the euro. But even in a no-deal scenario, bond traders are likely to remain divided on what position to take.