Bank of England Governor Mark Carney is driving news headlines Tuesday in his regular hearing with the Parliamentary Treasury select committee. There appears to be a clear difference of opinion between the Governor and at least one other voting member of the Monetary Policy Committee (MPC) over how much spare capacity Britain’s economy has, which is important because it has implications for the onset of tighter monetary policy. The Bank’s published range of 1-1.5% is less spare capacity than Mr. Carney thinks there is. However, Martin Weale, an external MPC member, believes that there is likely to be less than 1% spare capacity.
Mr. Carney also noted that should the Scots vote to become independent from England in a forthcoming referendum, it would be a game-changer for the Royal Bank of Scotland (Ticker: RBS), which would likely move its headquarters south of the border. The British government acquired 63.9% of Royal Bank of Scotland during 2008 when the financial crisis threatened its survival.
It has become apparent in the past six-months that the British economy has stepped up a gear. The question for central bank watchers is not who is right on how much spare capacity the British economy faces, but rather how both the currency reacts and how inflation pans out. Investors typically fear that inflation will tick-up and force the central bank to lift interest rates. During the recession the Bank of England had been known to fight back against expectations of premature monetary tightening. The Bank has also embraced the Fed’s policy of increasing reliance on forward policy guidance.
The brisker pace for the economy and signs of conflict over how heated – or not – the economy is becoming is likely to provide a spotlight on Britain’s banking stocks. A rising interest rate environment – whether only assumed by the fixed income market or not – is often seen as better news for lenders. The steeper yield curve in advance of an assumed set of policy rate increases tends to widen the spread between a bank’s deposit base and its lending rate to customers.
As we examined the price structure of further-dated options, it appears that investors in the Royal Bank of Scotland are decreasingly optimistic about its prospects. The following chart compares the current implied Probability Distribution for RBS with that of February 13th when its shares traded at £344.00-pence. Since that time they have declined by 10% to stand at £311.50-pence.
Chart – Optimism over banking prospects has waned over past four weeks
There are two points to note about the message conveyed by the options market. First, is the wholesale deterioration in prospects for shares in RBS as shown by the downwards shift between the two Probability curves. Second, investors no longer expect shares in RBS to trade higher than they were a month ago at any time over the next two years. The market implied price for December 2016 expiration has fallen 14% during the last month to £333.95-pence. That number roughly approximates to the consensus 12-month forecast of £334.12 among 25 analysts surveyed by Bloomberg, which is 13% lower than its January peak at £378.50-pence and 16% below its 52-week high achieved in October at £387.50-pence. Some of the restrained outlook can be blamed on the strong defensive nature of options premium at lower strikes as shown by the December 2016 Probability Distribution in isolation.
Chart – Pessimism displayed by strong defensive skew
We are accustomed to seeing a neat bell-shaped curve when looking at Probability Distributions for forward prices. Indeed using the IB Probability Lab to review implied prices through December 2014 shows just that. It appears that option traders are positioning for unfavorable outcomes in the longer run, which makes less sense given the debate between Mr. Carney and Mr. Weale. One would think that there ought to be a higher chance of RBS being auctioned back to the public by 2016 than there is currently. To price defensively against a misplaced government sale makes no sense. If the British government was in any doubt about the success of selling its stake in the lender, it simply wouldn’t do it.
The chart shows that with shares trading at £311.50-pence, the market currently assigns a rather high 10% chance that by expiration in December 2016, shares in RBS will be trading below £160.00-pence (down 49%). On the other hand the option market currently infers a 27% chance of a 28% gain to above £400.00-pence and a 17% chance of a close above £500.00-pence (+61%) by then.