Scottish Referendum 100 Days and Counting

The Scottish referendum will be held in 100 days, on September 18. The referendum is fundamentally as different from the referendum in Crimea, or the one proposed by Spain's Catalonia, as a prize fight is different from a bar room brawl. The former is conducted within established guidelines that govern such activity. The latter is not. 

The question before Scotland is an exercise in clarity and simplicity. " Should Scotland be an independent country?" There is little scope for confusion. There is no threshold in terms of turnout that is required. The one innovation was to lower the minimum voting age for the referendum to 16 from 18.

If lowering the minimum voting age was meant to bolster the "yes" vote, it does not appear to be working. Polls have fairly consistently shown the "no" camp ahead. However, the debate is likely to become more passionate as the date draws near.

A "yes" vote would obviously have more impact than a "no" vote. If Scotland did vote in favor of independence, there would be about an 18-month period of preparation and serious negotiations with the UK. On key macroeconomic measures, like population and GDP, Scotland is 8-9% of the UK. The critical negotiations will be over how much of the UK's debt should Scotland finance, as the UK will remain responsible for it all. Related to this, but separate, is the currency that Scotland would use.

If Scotland commits to financing the share of debt in line with its relative GDP or population, a new independent Scotland may find itself with a debt burden of close to 100% of GDP. Moreover, its deficit may be on the magnitude of 10% of GDP. If Scotland refuses to compensate the UK, its own creditworthiness will likely be questioned. It may also weigh on the UK's rating.

The UK government has tried to play hardball, arguing that an independent Scotland could not use the pound as its currency. Scotland can still do so, via a currency board or a new Scottish currency that could be pegged to the pound. Such a currency regime, which is the least disruptive, also curtails the very independence Scotland ostensibly seeks.

Arguably Scotland's independent drive is a function of at least a couple of forces. First, Scotland has been pushing for greater local rule since 1997. Since 1999, some central government activities, such as education, transportation and health, have been transferred to Scotland in what has been called devolution. Second, the rise of the Scottish National Party, which won a parliamentary majority in 2011, should be also understood within the context of the political push back against austerity, seen recently in some of the EU parliamentary races. The SNP had campaigned for greater home-rule, in areas such as pensions and passports.

There may be some knock-on implications for the UK general election next May, eight months after the Scottish referendum. A victory of the "yes" camp in Scotland and the "loss" of Scotland would likely become key campaign issue. Even if an independent Scotland can be laid at the feet of the Conservatives, the loss of Scottish MPs would be a blow for Labour. It seems ironic, with the apparent increasing support for the UKIP and a faction of the Conservatives that want to ally with Germany's AfD (anti-EU party), it has rejected the kind of federalism on the European level that it claims to want Scotland to accept on the national level.

In a larger sense, the Scottish referendum is only one several considerations that we expect will boost sterling volatility in the coming months. The three-month implied volatility is just above 5.0%. It is at the lower end of where it had traded since at least mid-1996, when Bloomberg began collected the data. The 10-year average is closer to 9.5%, to put it in perspective.

In addition to the Scottish referendum, there are significant personnel changes at the Bank of England's Monetary Policy Committee, which in the past has been associated with an increase in volatility. Meanwhile, another part of the BOE may seek to impose new macro prudential measures to check the price of houses in the UK, that are rising particularly quickly in the south, including London. On top of this, a hawkish faction at the MPC appears to be coalescing, which may lead to increased speculation of a rate hike in Q1 15, ahead of the May national election.

The correlation between sterling and implied volatility (3-month implied) has turned positive (at the level of percent changes) on a 60-day rolling basis since late April for the first time since 2007.  However,  we suspect that the risk of higher volatility will coincide with sterling declining. For medium term investors who want to hedge their sterling exposure with options, may consider buying puts as opposed to the cheaper and more conservative strategy of covered rights.