Why SONIA is bored of Brexit

UK interest rate markets responded much less than GBP to the Brexit referendum in 2016. Both short-term and long-term rates fell on the news that the “leave” vote had carried the day, correctly anticipating that the Bank of England (BoE) would ease policy. Unlike the GBP, however, rates quickly recovered to their previous levels and they never displayed any exceptionally high volatility (Figure 2).

The reason why the currency is engaged, and the interest rate markets are bored, comes down to one of economics. Depending upon the terms of the divorce (or if there is a Brexit at all), trade barriers with the EU could be anywhere from non-existent to minor to quite significant. This has a big impact on GBP. Moreover, currencies often move in ways that anticipate changes in trade barriers. For example, after the 2016 election, the Mexican peso slid 20% versus the U.S. dollar in the next two-and-a-half months fearing that the new U.S. Administration could tear up NAFTA. Likewise, when the US imposed a 10% tariff on $200 billion worth of Chinese goods in May 2018, the yuan fell 9% against the USD in the next four months. In short, anticipated slowdowns in trade matter a great deal to currency demand.

The implications of Brexit for UK interest rate markets are less clear. In general, a ‘hard’ Brexit is seen as bearish for the UK economy and interest rate levels (and therefore bullish for bond prices). However, Brexit’s interest rate implications aren’t quite so clear. A ‘no-deal’ Brexit would likely weaken the GBP, creating both a temporary surge in inflation and partially offsetting the negative economic impact of higher trade barriers from the EU. On balance, higher inflation is bad for bonds but not as bad as potentially slower growth. By contrast, a Brexit with a trade deal, or no-Brexit at all, might be bullish for UK investment and interest rate levels but it’s also likely to send the GBP soaring, which will make UK exports less competitive, limiting economic gains and repressing inflation. Hence, no matter what happens with Brexit, UK rate markets are likely to take it much more calmly than the currency markets.

SONIA and other UK interest rate benchmarks may appear to be bored of Brexit but that doesn’t mean that there isn’t risk regarding the outcome. 

If the UK heads towards a no-deal Brexit, rates could fall further, and one can’t even exclude the possibility of the BoE even cutting rates to buffer any negative impact, although given the tightness of the labor market this might be a tall order. On the other hand, if a deal is reached, it’s easy to imagine SONIA futures pricing in one or two more rate hikes over the next year and winding up with a significantly steeper forward curve (Figure 3). The UK employment market is roughly as tight as that of the US (Figure 4) where the Federal Reserve has hiked nine times. While UK inflationary pressures are mild, once Brexit’s fog of uncertainty lifts, there could be a path towards higher rates.

Both GBP and UK interest rates are bearishly positioned ahead of Brexit. In the event of a deal, look for GBP to rally quickly and the SONIA curve to bear-steepen. Even an EU-UK agreed lengthy delay would probably see a similar reaction to a deal. In the event of a no-deal Brexit, GBP might plunge initially, and interest rates could fall, but the market may get to a point where even a no- deal Brexit couldn’t be worse than what markets have priced, making even a no-deal outcome a sell-on-the-rumor, buy-on-the-fact (or, perhaps, a few weeks after the fact) event.