We suspect the market is underestimating the risk involved with the Catalonia independence movement. EUR/USD 1 month implied volatility continues to decline despite potential event risk.
Markets generally price the most obviously path of events. Hence why markets always get caught flat-footed by extreme events. Depending on what media you chose to watch will significantly influence your view of the situation. Over the weekend, demonstrations in Barcelona against independence helped lessen uncertainty. While threats of migration of large corporations out of Barcelona convince capitalist thinkers that logic and “common” sense would find a market-friendly resolution.
Pundits suggested momentum had shifted to moderate independent groups. However, we should use Noble prizewinner Richard Thaler’s work in behavioural economies dealing with “irrationally” to guide us. Or we can just remember how a similar corporate-line mislead most investors on Brexit. No, after Spain and Europe's recent actions, we suspect that Catalonia’s have hardened their resolve for independence. The separatists have been extremely quick since Monday, and that would hint as to coming strategy. Yet Madrid raised the stakes as Spain’s Deputy Prime Minister, Soraya Saenz de Santamaria, announced in a press release that the Spanish government would trigger article 155 if Puigdemont declares independence. A move widely expected, but one drew a clear line in the sand.
Pushed in a corner, in our view the separatist's next move will be the declaration of independence - most likely today. Madrid would trigger Art 155 of the constitution, which would dissolve key Catalonian powers and allow the central government to take control. The article has never been activated and guide lines are grey.
Yet the move will be seen as a clear escalation. What come next in our view is extremely unclear. Yet we are not ready to concede an orderly solution that requires constitutional changes and reliance of ratification by two-thirds of the Spanish parliament. The act of declaring independence would indicate that the movement no longer considers Spain legitimate and unlikely to continue through traditional constitutional process. In the near term we remain short on EUR and see current EUR/USD rally to 1.1780 as an opportunity to reload a short position.