What You Need To Understand:
The stakes are high, yet the explicit implications are unclear. A vote is to be cast by the electorate of the United Kingdom whether or not to remain a member of the European Union. The majority outcome will determine not only if the United Kingdom will withdraw from the EU, but could also impact credit ratings, reserve currency status, and the economic future the United Kingdom.
Because markets trade on anticipation of future outcomes, the volatility will likely be greater leading up to the event than days after the outcome is known. You should know the potential effects of staying and leaving and what each outcome could mean to the Euro Zone as a whole and the currencies on the fringe of this important election.
When Is the Vote?
On June 23, the UK electorate will be looking at the following ballot paper in the United Kingdom:
Who & What to Watch: Cable, Credit, & Cameron
David Cameron, the Prime Minister of the United Kingdom, lies front and center of the existence of a Brexitvote, and the negotiation should Britain remain in the EU. The bimodal campaigns of stay or leave are effectively voting on trade, EU budget, regulation, immigration (which has become a huge sticking point due to the Syrian war), and influence of Britain’s economic influence going forward.
The genesis of a Brexit vote was part of PM David Cameron’s 2015 reelection campaign that he announced in 2013 as a strategy to strengthen the relationship between Britain and Europe in hopes to make a good relationship better. However, the negotiation might end up being the undoing for now of the conservative party if the rising UK Independence Party or UKIP gets their preferred outcome.
In addition to David Cameron’s argument, the economic implications and initial shocks are going to be front and center of the reasons why people want to stay. Therefore, as new polling results come in it will be important to watch how Sterling trades, as well as credit, is being priced, which reflects perceived risk of repayment in the market. At the end of February, large banks such as JP Morgan, Goldman Sachs and HSBC, who have large exposure to credit and ongoing operations in the country in Britain have sided with David Cameron in saying the benefits of staying in the EU outweigh those that the ‘Vote Leave’ campaign see for leaving.
What’s on the Table?
The attention is currently centered on the implications for the United Kingdom. However, you should not dismiss the negative implications to the European Union losing one of the wealthiest EU nations, which could provide a further argument for the exit of other large countries that support the entire Union such as France.
The unintended consequence of the United Kingdom having the ability to leave has already provided a sense of unfairness in the 28 EU nation agreement. French President Francois Hollande & Maltese Prime Minister Joseph Muscat were quick to see that their countries see similar treatment of being able to share in the potential social benefits that the United Kingdom is seeking. Regardless of the outcome, while an agreement for Britain to take EU initiatives to a referendum passed in 2011, there is an unmistakable display of a two-tier system with Britain receiving special considerations that will likely put further strain on the European Union economic agreement.
Therefore, even if Britain decides in favor of the “Vote Stay in EU” group, the discord created by one member being able to leave will likely have ripple effects that will be dealt with for years to come. One thing that Britain will try to avoid should a Brexit be cast is not to disrupt the relationships with the majority of their trading partners that lie within the EU. Currently, seven of the nine largest trade partners of Britain are EU members and the risk of losing one of those would be great.
What’s At Risk?
AsBrexit risks increase on the back of polls, investors will likely remain focused on cable and credit ratings. Because Britain would be leaving one of the world’s strongest trading blocs on their accord, and not being forced out, there are a few relatable precedents to understand exactly how this will play out. The key focus will understandably be on Britain’s credit rating as they are already in an account deficit and a Brexit could further stress their economy as noted by the S&P:
”In a worst-case scenario, a Brexit could also harm the sterling’s role as a global reserve currency, removing what has been a significant support for our AAA rating on the UK since the start of the global financial crisis.”
-Standard & Poor’s Statement following the EU deal & Boris Johnson’s Brexit Backing
Should trade relationships that were stable and provided consistent revenue to the United Kingdom deteriorate, attention will turn to the Bank of England. They may be cornered into having to provide looser monetary policy on a weakening growth outlook in the short run despite inflation risk that comes with a weak currency. Looking at the overnight index swap market shows investors favor a cut by the Bank of England rather than a hike over 2016. Therefore, the currency effects of a more dovish Mark Carney, the governor of the Bank of England would likely come as little surprise as GBP fails to find bids in the market.
On Friday, February 26, 2016, an ominous warning came from Markus Kerber, director generalof the Federation of German Industries,who noted that a Brexit would mean a needed revision to thousands of investment contracts involving U.K. and German companies. In not wanting to mince words, Kerber said, a Brexit, “wouldn’t be an amicable divorce…I think the damage for both sides in a Brexit would be very big, but bigger for the U.K. as 50 percent of its trade is with the EU.”
As we have seen in the financialcrisis of times past, the risk tends to begin and end with credit. Aside from Standard & Poor’s statement above, there is appropriate fear that creditors in the United Kingdom and those with balance sheet exposure to British borrowers could be seen as riskier if a Brexit vote hurts the economy worse than expected. While confidence and credit ratings go hand-in-hand, markets tend to overreact in the short-term and watching credit default swaps, a financial market insurance product to hedge against a sovereign or corporate default, should be watched to see if confidence in credit fears are rising along with the price of swap insurance.
Equity Effects: The FTSE 100 & GER 30
As a services-based economy similar to the United States, many of the financial service firms would be the most distressed by a Brexit. In the last week of February, banks have begun sounding the alarm of needed restructuring out of the United Kingdom’s financial district should a restructuring take place.
JPMorgan CEO Jamie Dimon noted on February 23 that a ‘Brexit’ would bring “massive dislocation,” to London’s financial hub causing UK-based banks to be no longer able to operate as they had if Britain leaves the EU. In Mid-February Mr. Dimon also noted “Britain’s been a great home for financial companies and [EU membership] has benefited London quite a bit. We’d like to stay there, but if we cannot, we cannot.” In other words, you can likely expect voters that are employed by the financial services companies in the city to prefer staying and avoiding a potential short-term employment disaster for London.
Chart Prepared by Tyler Yell, CMT
The Key Charts:
The problem with buying low and selling high is the emotional battle within. At high prices, everything is rosy, and the investor’s mind often tells them to buy more. At low prices, when everything is in dire straits, which was a predecessor to low prices investors often want to sell more. On a simple chart going back to the late 90s, where London’s stock market recovered wonderfully from the 1992 crisis when London left the ERM, you can see we are pushing off a high price for the third time. While simplistic, this chart may show that optimism to the upside has run its course, and the reason to sell has been switched out from internet boom-bust to housing crisis, to potential Brexit.
However, if the Brexit becomes the economic equivalent of clumsily pulling a rug from under a tier of champagne glasses, we will likely see selling pressure elsewhere. Given the distinct ramifications in the EU, the focus should equally be on the German DAX 30. The long-term weekly chart of the DAX shows late February price putting pressure on the 200-week moving average, which is also shown on the FTSE 100 chart above. A sustained break below that level near 9,150 would likely cause pressure to mount up in regional equity indices. The assumption would be for further selling and lower prices in both the GER 30 & FTSE 100.
Chart Prepared by Tyler Yell, CMT
Political Heavy Weights Are Picking Sides
One of the critical developments that came out over the weekend on February 21 was that Boris Johnson, the uncommonly popular mayor of London has decided to back the Brexit view, although he did say it was an “agonizingly difficult” decision. Because the polls are nearly evenly split with roughly 45% preferring to stay to the 40% preferring to leave, the effectiveness and momentum of Boris Johnson’s decision could soon see a consistent shift in the polls towards the Brexit vote. An Ipsos Mori poll showed that almost 1/3 of the electorate that responded noted Johnson’s opinion would be an important factor in their voting decision.
Track Trader Sentiment In Real-time with DailyFX Speculative Sentiment Index
Traders should keep an eye on trader sentiment for GBP/USD as anticipation builds around the future of GBP in light of the Brexit vote. Currently, retail traders as shown by DailyFX Speculative Sentiment Index above have been fighting the GBP sell-off while IMM data shows despite investors aggressively selling GBP this year, the sharp volatility this year has washed out a lot of GBP positions. This positioning data means there is still money on the sidelines that could push this market lower even against the retail positioning who often tries to “buy low” in strong downtrends. Currently, IMM positioning has dropped to levels that were last seenaround the SNB-shock of January 2015. A reloading of short Sterling trades could see a retest of the 2001-2009 low of 1.35/36.
Chart Prepared by Tyler Yell, CMT
Probabilistic Outcomes in FX:
The obvious first place to start on a Brexit outcome is with a GBP negative view. A Brexit may force Mark Carney and the Bank of England to hold off raising rates even further. Currently, futures markets are pricing and more cuts over the year than hikes, which is clearest seen in the two-year gilt that is yielding below the current Bank of England reference rate of 50 basis points at nearly 35 basis points.
However, the better opportunities and trades will likely come from incomplete information on the secondary ripple effects of a Brexit. As noted above, Britain leaving the European Union will turn the doubt towards the existence and sufficiency of the union itself, which German Finance ministers have also been discussing with a plan to impose “haircuts” on holders of Eurozone sovereign debt before further bailouts are issued. Therefore, the confidence crisis in the Eurozone kicked off by aBrexit carried by the German Council of Economic Advisers to appropriately price sovereign risk within the Eurozone and force bondholder losses before a bailout could turn the negative effects across the pond to the EUR.
As for currencies that could strengthen, theBrexit vote passing in favor of the “Vote Leave,” campaign would add to a laundry list of global macroeconomic worries that would likely further propel the JPY and CHF higher along with gold. JPY and Gold in 2016 have thus far been the top performing markets. If a further destabilization happens in the commodity markets, emerging markets, and potentially the Euro Zone we could see further strength in the yen that has a chart set up longer-term on GBP/JPY that could make for an attractive sell on a break below the 200-week moving average similar to 2008.
Chart Prepared by Tyler Yell, CMT
Another currency that could come out shining from a “Vote Leave” win would be the US dollar. If the Standard & Poor’s proposal of a credit rating cut would take Sterling out of the reserve currency status, capital could shift aggressively into the US dollar in such a move would likely further propel the Japanese Yen. While this is the least certain outcome/most speculative, a downgrade of the British pound out of reserve status would not only put intense 1992-style pressure on the pound, but that money could find its way in US dollars propelling the greenback ever higher. Such a dollar appreciation would be a major disappointment to the dollar-denominated debt holders in emerging markets, and likely the Federal Reserve.
The Brexit Takeaway
High conviction bets are scarce now. As we saw during the Scottish independence referendum vote, markets will likely swing violently on new poll outcomes and most violently on a takeover of the leave vote campaign. The Sterling move on February 22 was the most volatility the pound has seen versus the USD since 2011 and has taken us to 2009 levels, but we could surpass those levels to see 2008 levels of volatility limited not only to Sterling but other negatively affected currencies as well.
Understanding what is going on, who is affected primarily and secondarily is very important and helpful for investors going forward up to and through the June 23 vote. While much attention will rightfully be placed on movements in percentile terms of sterling, do not forget how efficient markets are at pricing the main story while at the same time being magnificently inefficient at pricing in the story behind the main story. Chances are, the ripple effects of a Brexit will stir the pond as much as the initial outcome.
-Tyler L. Yell, CMT
Source: Daily fx
