Will Sterling volatility remain post the UK’s EU Referendum result?

08/06/2016

By Lee Camp, Finance Director, Merchant Banking

Since the announcement that the EU Referendum will take place on 23 June, it’s become increasingly apparent that investors are genuinely concerned about the future value of the Pound against other paired currencies.

Over the past six months, GBP/EUR has generally traded in tandem with the Standard & Poor’s 500 index up until mid-February when it showed a noticeable divergence as the market began pricing in the risk of a Brexit.  Implied volatility in Sterling has also increased considerably since the turn of the year, which is probably the most accurate reflection of uncertainty.

Both one year and six month implied volatility in GBP/USD are now higher than the same measures for EUR/USD, which had historically been lower ever since the introduction of the Euro in 1999.

Over the past month alone we have seen GBP/USD lows of 1.433 and highs of 1.475, GBP/EUR lows of 1.260 and highs of 1.3150, a level not seen since February 2016. GBP/CHF has traded between lows of 1.383 and highs of 1.449. The pound is extremely sensitive to Brexit and the markets have seen Sterling rallies as a result of campaigning to Remain as well as falls off the back of promotions of the Leave vote.

At its meeting on 11 May, the Monetary Policy Committee (MPC) voted unanimously to maintain the UK Base Rate at 0.5%. The MPC have said that the most significant risk to their forecast concerns the referendum as a vote to leave the EU could materially change the outlook for output and inflation. Current market pricing suggests that we won’t see a hike in UK interest rates until 2019, with the possibility of a rate cut over the next year.

In the event of a Leave vote, it is expected that there would be a sell-off of Sterling. The forecast volume of the sell-off is extremely difficult to predict given the lack of historical precedence. The closest event in recent memory would be when Britain was forced out of the Exchange Rate Mechanism (ERM) during ‘Black Wednesday’ in September 1992. Following the exit from the ERM, Sterling dropped 15% against the US Dollar in the space of just a week, ending the year on a 25% low. This would suggest that Sterling has less to fall in the event of a Brexit than it did following the withdrawal from the ERM.

In the short-term, financial markets would probably show the most vigorous reaction. There would be a further depreciation of Sterling and the City consensus is that there would be a strengthening of the USD as a flight to safety for global investors. Equities would no doubt suffer a mild contraction as they factor in risk. London-based currency traders International Foreign Exchange (IFX) believe that the accommodative monetary policy that would follow would re-strengthen these global indices.

Conversely, an ‘in’ vote and the resulting clearing of uncertainty is likely to bring about a Sterling rally.  Recently Sterling surged over 5 cents against the Euro moving from a low of 1.2670 to hit a high of 1.3180 upon the release of two polls showing voters had swung towards remaining in the European Union. The survey found that almost half of those questioned thought the economy would get worse over the next five years if Britain quit the EU. Over the longer term, a narrow majority – 39 per cent against 35 per cent thought Brexit would have a positive economic impact over 10-20 years. Just 18 per cent said that leaving the EU would improve their own standard of living, compared with 29 per cent who thought it would harm it.

An ‘in’ vote would also lead to markets quickly removing expectations for a rate cut and start pricing in the chance of a rate hike at some point.  IFX’s forecast is that the Bank of England will raise interest rates in the first quarter of 2017, provided the UK remains a member of the European Union.

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This article is part of our June 2016 Private Office Newsletter.

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