Tuesday, June 14, 2016

Trade Ideas: Cheap Brexit Hedges

The Brexit noise and fear in the markets are getting ever louder. Handful of opinion poll results have led to extreme volatilities in currency and equities markets. It is something that no longer can be written off and hoped against. Unfortunately for investors, hedging such a macro event is neither easy nor cheap.
This blog discussed about a cheap Brexit hedge previously, here we take a more systematic approach.
Hedging macro event such as Brexit involves defining scenarios and associated outcomes in terms of market variables in each scenarios, and then picking the outcomes we want to hedge against. Then it becomes an exercise in balance between the cost of hedges and the residual risks (including basis between investor portfolio and hedge as well as the risk of the particular scenario/outcome assumed not realizing). Defining expectations about scenarios and outcomes of a such an uncertain event is not straightforward. Beyond economic analysis, what matters most in near terms is what market participants perceive as the possible impact, and also what they expect others to expect as possibilities - and make the most out of it. The resulting outcome can turn out to be quite different than what is based on pure economic outcome. However, at present, it is generally agreed that in the event of a Brexit, sterling pound will sell off considerably.
Taking this as an anchor, we analyze cross asset markets for their correlation (rolling weekly) to sterling pound. The figure below shows the outcome. On vertical axis, we have the correlation to sterling pound (GBP) in percentage point. On horizontal axis we have the relative rich/cheap position of each asset (z-score since 2014 beginning). If our assumption is right about a GBP sell-off and if these correlations hold, to hedge positions one would short the assets on the top half and go long on the bottom half. Also from relative value point of view, you want to short assets as far to the right as possible (rich) and reverse for longs. Hence the ideal hedging assets will be diagonal from top-right to bottom-left.

The motion chart captures time evolutions of these correlations. Drag the slider to the latest date. As we can see the most effective hedges (apart from shorting GBP/USD of course) is shorting GBP/EUR. However, in terms of cheapness the GBP 5y cross-currency basis swaps fares much better. In equity space, shorting FTSE vs. EM is attractive too. In rates space the best is shorting USD vs. EUR  10y swap rates (pay EUR swaps). On the bottom half, the best hedge is long euro FX volatility.
Looking around, to position for upside, shorting FTSE vs. Euro Stoxx looks quite attractive.
The trades here:
#1: long calendar spread in Euro FX straddle: discussed in more details here.

#2: short EUR 10y vs. USD in swaps: With Germany 10y hitting negative for the first time, there is very little scope of move further down here. On the other hand, in the event of an actual Brexit happening, any substantial margin calls can transmit risks asset selling pressure to safe assets. This appears more true as it does not look like there is a high amount of defensive positioning around the event. And given the expected tight liquidity in such a scenario, this can very quickly lead to a significant sell-off in euro rates. On the monetary policy side, a Brexit will definitely push down US yields further, pricing out any Fed hike (or even active easing). ECB, on the other hand has little traditional room to push rates down. My theory here is that a policy rate cuts has much less latency in market reaction than asset purchase can ever achieve in a stressed situation.

#3: short GBP short term (2y or 5y) cross currency basis swaps. In  the event of a Brexit, potentially we will have a significant demand in USD funding from UK players. In fact a more risky version of this trade is to short GBP basis vs. EUR. The former is trading far richer compared the later. And presumably given the cross-border exposures of UK to Europe, we may see a significant spike in euro demand as well to fulfill near term obligations of UK financials institutions.

Equities do not offer much attractive hedges after the recent sell-off (although shorting FTSE vs. EM equities can be considered). Equities however offer more attractive upside positioningfrom these levels (see above).

1. All data from FRED database/ Bloomberg
2. Symbols Key in the Chart - GBP10Y: GBP 10y Swaps, GBP5S30S: GBP swaps 5s30s slope, GBPBS5Y: GBP 5y cross currency basis, EURBS5Y: EUR 5y cross currency basis, GBPMMSPREAD: GBP 1y1y money market vs. libor spread, FTSE: FTSE100, VIX: CBOE VIX, GBPEUR: GBP/EUR cross, GBPJPY: GBP/Yen Cross, PERIPHERAL: Germany/Italy 10y bond spread, INFLATION: GBP 5y breakeven inflation, EURVOL: EURUSD 3M Vol, USDEUR10Y: USD/EUR 10y swap spread, GBPEUR10Y: USD/EUR 10y swap spread, USDGBP10Y: USD/EUR 10y swap spread, USDGBP5S30S: USD/GBP 5s30s Spread, USDEUR5S30S: USD/GBP 5s30s Spread, FTSEEU: Long FTSE vs. Euro Stoxx, FTSEUS: Long FTSE vs. S&P500, FTSEEM: Long FTSE vs. MSCI EM Index.

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