FX Event of the Year Candidate: June 23 Brexit Vote explained by professional Forex trading experts the “ForexSQ” FX trading team.
FX Event of the Year Candidate: June 23 Brexit Vote
A Full Brexit Breakdown
The Brexit is coming! Or is It? Polls are split, but either way, if you are a Foreign Exchange trader or someone with exposure to stocks or business in the European Union or the United Kingdom, it can be very helpful to understand what is on the line and what the implications could be and how they might affect you.
What is a Brexit?
Great question! A Brexit would be the removal of the United Kingdom from the trade partnership with the European Union.
The term is a quip, but it is meant to communicate a British Exit. While it may sound as boring as the Smoot-Hawley Act on its surface, it’s implications are far reaching, and such an event could be a market defining the occurrence of FX in 2016 and beyond.
On June 23, the electorate of 18 and older in the United Kingdom will decide whether or not it is in the best interest of the country to remain trade partners. Being trade partners has a lot of benefits that many people don’t think of so we’ll explain them here all the while not passing judgment on either side since both sides have credible arguments. However, given the implications, it’s not surprising that the media has particular preferences like the British Broadcasting Channel (BBC), which was said to show clear evidence of covering stories and bringing on guests that would mainly explain the benefit of staying in the EU as opposed to leaving.
This is a major Fundamental event in FX.
The EU Benefits of Staying in the UK
The largest voice to many FX traders on either side of the debate is that of the Bank of England. The governor of the Bank of England, Mark Carney, has recently come out to explain the trade disruptions and steps backward of economic progress that a Brexit would bring about.
While his statement has been criticized as fear mongering, his statement is simply that trade and capital flow will be hampered should a Brexit Develope and staying in the EU will allow the UK to stay the course toward growth and recovery. However, the British Pound has weakened recently on understandable fears of leaving, and the Bank of England has mentioned that the uncertainty of the vote means that now is not the time to raise rates.
Who Wants to Leave & Why
The list of who wants to leave the EU from the UK is in flux. Right now, the big three in purportedly that have been mentioned to stay in the EU are George Osborne, British Conservative Party politician who has been Chancellor of the Exchequer since 2010 and prime minister David Cameron are in the ‘Vote Stay’ camp, and Mark Carney, the governor of the Bank of England, has noted the adverse trade effects of leaving the UK’s largest trade partner.
In the Vote Stay camp, the popular Mayor of London, Boris Johnson has the view that Britain could come out of the Independence Referendum unscathed and could become more like Canada. To this end, he does not believe there is an ‘Economic Shock’ risk that the Vote Stay camp is forecasting on a Brexit vote.
Instead, Johnson believes the most favorable economic outcome would be a Brexit.
Currencies to Watch & Why
The obvious contender here is the British Sterling Pound. As you can imagine, there will be a lot of capital flow in anticipation of the event out of the United Kingdom. It could be argued that a majority of that move has already happened, but unfortunately, only time will tell. However, the warning from the Standard & Poors shows that capital may be forced out if a Brexit vote succeeds. As per Moritz Kraemer, chief rating officer for S&P, “We’ve been quite unambiguous saying that if Britain leaves the EU, the sovereign rating would go down by at least a notch.”
There is a lot (maybe even the majority of capital) that is unable to stay in any instrument that is based in a country which is below a certain credit rating.
In other words, if the credit rating in Britain is cut by a notch on a Brexit outcome, more capital will be forced out of the country, which will nearly ensure an environment of volatility and likely GBP weakness.
The longer-term effects will likely be equally felt by the European Union, who is at risk of losing a key trading partner who pays hefty fees (a reason the UK is arguing to leave) and upsetting the partners who remain. We’ve already heard from the PM of Malta
The other two focal currencies outside of EUR/GBP, which is effectively ground zero of the negative effects, should a ‘Brexit’ come to fruition are the US Dollar and the Japanese Yen.
The Japanese Yen is almost always a sure-fire bet to strengthen when risk-off sentiment rises. While there are many scenarios that we can look to over the past 2-years, one lesser known political event in many traders’ memories unless you were trading on that day (that includes yours truly). On February 25, 2013, Italian PM Elections (which in some respects have a similar tone to the 2016 presidential election) put the financial world on the edge of their seats as they waited to see who would lead the country with the third largest bond market.
As a three-way battle ensued, European bourse markets were rattled, evidenced by a nearly 5% plunge on Italy’s MIB. Italy’s borrowing costs increased, as the yield on its 10-year bond moved toward 5%, triggering similar moves in weaker eurozone states such as Spain and Portugal due to the size of the bond market.
On that day, EUR/JPY moved lower by 625 pips as the potential outcome of a protest movement led by comedian turned politician Beppe Grillo seemed too much risk to handle. It’s not difficult to imagine a similar move in GBP/JPY on a ‘Brexit’ outcome as the uncertainty of the negative effects would likely be great than that of a former-Comedian taking over Italy’s government. For what it’s worth, the Italian election turned out to be a non-event for Financial Markets as the outcome resulted in the center-left coalition of Pier Luigi Bersani winning by a very slim margin in the lower house of parliament.
The US Dollar is a natural benefactor as much of the money potentially forced out of financial assets in the United Kingdom would need to find another AAA-rated countryto park their capital in safely. While the JPY would likely strengthen aggressively, the US Dollar could as well as US Treasuries are bought resulting in a significant capital flight into the US Dollar. In addition to capital flow disruption, major trade flow disruption is also at risk.
Potential Trade Partner Disruption
When you start working on a Foreign Exchange desk, you’re taught two key drivers of the FX market. They are trade and capital flow, and at different times in an economic cycle, one will be a dominant force in the FX market over another.
To understand the potential trade partner effects of a Brexit, it pays to listen to the arguments (outcome certainty is impossible), of the Vote Remain or Stay camp. Once again, they include some of the more prominent names in finance that affect the United Kingdom like George Osborne, PM David Cameron, & while not officially declaring his preference has argued that trade effects would be just short of calamitous for U.K. Trade.
One of the strongest warnings came from a key trading partner of Britain, Germany. Specifically, Markus Kerber, director general of the Federation of German Industries who warned that 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.”
The Only Valid Forecast Is Volatility
In the last week of March, FX traders were able to see how the options market were preparing for the big event. This is done for by following Implied Volatility over a specific period of time. As of March 23, the GBPUSD 3M ATM implied volatility includes the pricing in of the date of the British referendum.
As a quick refresher, Implied Volatility is the estimated volatility of a market or in this case, the GBP/USD price. In general, implied volatility increases when the market is bearish, and a jump is nearly synonymous with preparing for aggressive downside via options. While some people buy Implied Volatility as a hedge, others simply sell the currency. On Wednesday, Implied Volatility for GBP/USD rose by 20%, reaching its highest level since 2011 today and may continue to rise alongside the fears of a ‘Brexit’ coming to fruition.
What To Watch Leading Into Brexit
If two key events will be watched heading into the June 23 referendum to price in the risk of a Brexit, it would be the polls and the debates. The polls are helpful, but altogether an incomplete picture of what will unfold on a June 23. The polls, however, did drive risk leading up to the Scottish Independence Referendum.
The other key event will be the debates. The debates are critical because there is nearly 20% of the electorate that is undecided. One of the largest debates will be on Thursday, June 21 between the Mayor of London Boris Johnson and the Chancellor of the Exchequer, George Osborne. If the number of undecided remain relatively high, and their sway will determine the election, then the debate being held 48 hours before the vote could be a significant driver of the outcome.
Another component that is a wildcard is the recent bouts of terrorist attacks like we saw in late 2015 in Paris and the end of March in Belgium. It is important to understand why the terrorist attack in Brussels was so GBP negative. With 20% of the electorate undecided, and with the migrant crisis on the back of the Syrian war, there was a belief that the relatively loose migration policy of the EU would possibly swing the vote in favor of Brexit.
Should You Trade the Brexit?
If you want volatility to trade, the potential for a ‘Brexit’ has already delivered and will continue to do so. If your primary concern is capital preservation, you should only limit JPY & GBP exposure to very small. Chances are, you will have an opportunity to trade after the vote that could present very long lasting trends, and the financial world adjusts to the new normal or the same environment.
FX Event of the Year Candidate: June 23 Brexit Vote Conclusion
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