Currency gyrations intensify ahead of UK referendum

The roller coaster ride into the UK referendum on EU membership added new violent twists and turns over the last couple of weeks on two huge apparent momentum shifts in the voting. The last shift has been an apparent shift in favor of Remain after the tragic murder of Jo Cox, the pro-Remain Labour MP. Over the last two weeks, sterling has plunged some 10 percent versus the safe haven Japanese yen, only to rise almost 5 percent from last Thursday’s lows by early Monday hours.  

But even with a shift in the numbers, the FT’s “poll of polls” this Monday said it all, showing a 44% to 44% tie, with the rest undecided. The apparent tie represents a sharp reversal of prior days that saw the Leave side edging a few percentage points higher, but it’s worth noting that the sharp unwinding of that Leave percentage saw less of a bump in the Remain numbers while instead, the Undecided percentage jumped. Unfortunately for all of these indecisive voters, there is no Undecided option in the voting booth this Thursday.

Market observers and currency traders in particular are first and foremost interested in the binary outcome of the vote, of course. Will it be in or out? As well, however, many have pointed to the margin of victory as potentially decisive for the longer term path for the UK and its relationship with the EU. That’s more the case with a thin margin of victory for a Brexit vote, which some suggest could lead to a fresh referendum in short order once the UK has been sufficiently “sweated” by weak asset markets and a dip in the UK’s economic fortune, together with stern warnings from the EU on what separation might entail. There’s just as much possibility, of course, that any bullying from the EU leadership would backfire. So that leaves three outcomes currency traders must consider: Remain, Barely Brexit, and Clear Brexit. Let’s consider the possible market reactions in the currency market to each of these three scenarios.

The reaction pattern in the event of a Remain vote, even one with a close margin, would likely prove fairly straightforward. Despite huge structural imbalances in the UK and a yawning current account deficit that remain ongoing concerns for sterling, the lifting of the uncertainty over the referendum will also likely see an enormous lifting of Brexit hedges and a healthy dose of pent up demand driving a strong rebound in UK economic activity for the coming quarter or so. The pound would likely rally most in the near term against the Swiss franc and a US dollar struggling due to recent Fed dovishness. I’ll discuss in the future why a yen sell-off is a less certain proposition beyond the initial knee-jerk.

The reactions to a Barely Brexit and Clear Brexit will be far more volatile affairs, made even more volatile by the markets careening into the referendum with a fresh shift in the odds away from a Brexit outcome. As both the UK and Europe would be happy to see a weaker currency to help with low inflation figures, any intervention to stabilize the situation would likely only come as an attempt to prevent excess contagion into asset markets. In other words, if the Bank of England could get a 20 percent devaluation in sterling with no consequences for risk appetite, it would gladly take it.

The initial hours and days of trading after a Brexit vote should see white hot volatility, with a Clear Brexit vote generating the most energy and a significant initial move lower for sterling – perhaps a 10-12% move, even if most of the initial reaction is quickly unwound. Even with a Clear Brexit, the UK will get back down to business quickly and should see a strong bump in economic activity on the lifting of the uncertainty. In the event of a razor-thin margin for the Leavers, our Barely Brexit scenario, the market reaction may prove less volatile and may quickly shift into a nervous uncertain mode as the market fears an eventual second referendum down the road.

These scenarios are pure conjecture and we may be just as likely to see an exhausted market gyrating back and forth on any outcome before deciding that the entire situation was over-anticipated and the pound more or less settles at current levels within a few weeks as the market’s short attention span sees focus shifting to the status of the US economy, the November presidential election, and the timing and nature of the inevitable next round of BoJ action.