The probability of Scottish independence in the United Kingdom is being underestimated and risk is being mispriced in the market, a recent Deutsche Bank report notes.
Scottish independence polls narrowed sharply
The bank’s FX Daily report notes that polls have narrowed sharply since an August 5 television debate, as support to keep Scotland attached to the United Kingdom slips by 8 percent and is currently only holding on to a 6 percent lead over separatist forces.
“Equally worrying,” the Deutsche Bank report says is the turnaround for the separatist and their structural lead. The campaign could lead to very high turnout, nearly 80 percent are expected to vote. This is one of three issues that could lead to a tight election. This also includes a greater percentage of demographics that don’t traditionally vote and the fact Scotland’s political machinery is in the hands of the Scottish National Party could all lead to a close election.
If independence is granted, planning regarding economic ties need to be considered, which appears not to be the case.
Scottish independence could have a major negative impact on the Sterling
In previous reports, Deutsche Bank has argued that without pre-planning, as reports indicate is the case, the ruling UK government is risking financial stability if it rejects a currency union between what would be two separate nations. This could have negative consequences.
While the Bank of England has drawn up contingency plans, Scottish independence would be considered a major negative for England’s currency, the Sterling. If separation took place, the UK would lose its most productive region – and source of tax revenue. As a result, its current account deficit would broaden, deepening its debt wows, and a new border would be imposed with its now second largest trading partner, the report highlighted. Such a vote could lead to a delay in rate hikes and “raising the prospect of a null and void 2015 election.”
How should an investor play this situation? Buy volatility.
GBP/USD risk premiums
The Deutsche Bank report notes that volatility is relatively cheap as a result of the primary risks being underestimated. This affordability is despite the fact that short dated volatility having spiked by 6 percent. The report notes the currency play between the GBP/USD risk premium remains below that of the USD/JPY and EUR/USD currency spreads and is but only modestly above historic levels.
“With sterling long positioning having lightened, options may therefore be the best way to hedge in the coming two weeks,” the report noted, citing a derivatives investment.