A broad overview of currency arbitrage and implications as a result of the UK’s referendum vote.
Position on Europe:
- Short: European equities, Euro, EU debtor nation bonds
- Long: British equities, Pound, Gold
Equity indices took a hit around the globe on Friday as the UK referendum vote came in with 51.9% favouring to oust the UK from the EU. Rest assured, the short-term impact of Brexit on investment portfolios was ‘defensively’ hedged by most fund managers who promptly released statements to investors that assured them holdings were safe, at least in the near 6 months.
- Japan’s Nikkei 225 closed -4.15% lower this week at 14,952 [setting a new 52w low];
- Hong Kong’s Hang Seng closed 0.44% higher this week at 20,259 [sitting 23% above 52w lows];
- China’s CSI 300 closed -1.07% lower this week at 3,077 [sitting 14% above 52w lows];
- London’s FTSE 100 closed 1.95% higher this week at 6,139 [sitting 48% above 52w lows];
- New York’s S&P 500 closed -1.63% lower this week at 2,037 [70% above 52w lows]; and
- Toronto’s TSX closed -0.07% lower this week at 13,892 [sitting 69% above 52w lows].
Government Bond Yields
Government bond yields of advanced (risk-free) nations have continued to set new lows as portfolio managers continue to increase holdings of these low-yielding assets, while on the other hand we have Venezuelan 10-year bonds spike up towards a yield of 28%.
- US 10-year yields closed at 1.560%, a drop of 3% or 49 basis points for the week;
- CAD 10-year yields closed at 1.163%, a gain of 4% or 46 basis points for the week;
- UK 10-year yields closed at 1.086%, a drop of 5% or 57 basis points for the week and opposite to the convention that yields should drop on volatility and expected repayment risk; and
- GER 10-year yields closed at -0.047, a drop of 65 basis points for the week and is the first week Bund yields have closed Friday in negative territory (briefly closing at -0.025% last Thursday).
UK 10-year (White line) vs. German 10-year (Yellow line)
From the above graph, positions were triggered on the referendum vote in the UK resulting in UK and GER 10-year yields dropping>20% before recovering due to buying pressure.
Yields plummeted on news that the UK referendum decided an exit from the EU – yields move in the opposite direction to prices, suggesting that investors expect interest rates within the EU (including UK) could face a treacherous path downwards. (Note: the price of bonds react inversely to changes in interest rates – if bond prices go up or yields go down, this indicates an expectation of lower interest rate environment).
Additionally, pension and fund managers will have purchased short positions (most likely protective puts) against their LT bond portfolio, which have been required thanks to outdated fund mandates. This will have also contributed to the immediate drop in yield of UK and GER 10-year yields.
Two major currency movements noted this week: Yen and Pound.
As mentioned in last week’s market brief, the Bank of Japan released guidance that they may see intervention in the Yen to prevent further economic loss due to an already export-denting currency. As the Yen lowered to 102.15/$, we are nearing the mark.
GBP/USD vs. GBP/JPY Arbitrage
The above graph shows arbitrage positions in GBP/JPY triggered at 19:15, followed by a steeper appreciation in the Yen vs. the Pound against the USD.
The arbitrage position between Pound and Yen was triggered immediately after the vote, as the Yen could see further depreciation against the USD in the following months.
On the other hand, we could see a strong appreciation in the Pound over the next 12 months as uncertainty over the EU sets in and the British economy will generate a much needed push as its currency is now ca. 25-30% cheaper.
Soros was long Gold, were you?
As mentioned in the market brief two weeks ago, Soros transitioned from a zero position in Barrick Gold to its largest holding within the 3 month reporting period to March 31st, 2016.
The above graph shows the spike in gold prices (a safe-haven asset against currency movements, especially those appreciating against the USD), with the GBP/USD spiking on referendum results and the GBP/JPY depreciating as the JPY depreciated against the USD.
Gold futures (green line) spiked following the referendum vote – an upward trend most likely will continue given uncertainty over the EU:
- HSBC, Standard Chartered, Barclays are the three main banks headquartered in London with global operations – how will their balance sheets hold up?
- Netherlands and other EU nations are discussing EU exit, how will this affect outlook on commerical loan issuance and payback? Analysis of loan portfolio duration could give good insight.
- If we see the EU dispand and the Euro get broken up, how will already volatile currency markets adjust and which direction will German Bund yields move?
Soros made it clear in his Guardian op-ed that Brexit would not be detrimental to the UK (believe it or not) but fuel demand by debtor nations across the EU to exit, against the interests of creditor nations: referendum vote was brought on by the UK independence party – Italy’s Five Start Movement has just come to power in Rome, deja vu anyone?