By Kathy Lien, Managing Director of FX Strategy for BK Asset Management
Britain’s decision to leave the European Union triggered pandemonium across the financial markets. Currencies and equities were hit hard by the vote with sterling falling over 10% intraday. Friday was the worst day ever for the British pound and the 1.3230 low reached during the Asian trading session was the weakest level for GBP/USD in more than 3 decades. The last time we had a move this large was during the Global Financial Crisis and, before that, on Black Wednesday when the U.K. government was ejected from the European Exchange Rate Mechanism (ERM). Brexit will be worse than Black Wednesday – we see that in the price action of currencies and gilts and in the level of uncertainty in the market. Ten-year Gilt yields fell to their lowest level ever. Britain needs to invoke Article 50 to redefine its relationship with the EU but leaders of the ‘Leave’ campaign refuse to act quickly. The longer they wait, the worse it will be for sterling. The only U.K. market to survive with modest losses was the FTSE 100, which ended the day down only -3.15%. The index dropped as much as 8.7% intraday but pared its losses on the back of a weakening pound and hope for U.K. stimulus.
But the bloodbath isn’t over for the British pound because Brexit is the beginning and not the end of England’s problems. The next step is for the UK and EU to negotiate exit terms. And that will take months, possibly years. During this period, multinational businesses will refrain from making major investments in the U.K. economy and may in fact actively plan to move their headquarters and business operations over to the continent. There’s no question that during the next 12 months, the U.K. economy will pay dearly for Brexit – they’d be lucky if there was any growth at all in the second half of the year. S&P could strip its AAA rating and the Bank of England stands ready to cut interest rates if there is even a hint of recession. Thousands of words could be written about how damaging Brexit is for the U.K. economy but as currency traders, our main focus is the outlook for sterling.
GBP/USD ended “Black Friday” 400 pips off its lows, which is impressive given the severity of the country’s decision to abandon the European Union. In the days after Britain was forced out of the ERM, sterling fell another 5% and in the 2 months that followed, it was down 15%. So while we’ve seen an intraday recovery in GBP, we still expect Friday’s low to be revisited and broken. At minimum we expect GBP/USD to drop to 1.32 over next month, but the move could occur as quickly as the coming week. With no major U.K. economic reports scheduled for release, Brexit will continue to be the main story for the markets. When the U.K. decides to invoke Article 50, there could be a relief rally, but don’t be mistaken, that move should be sold into because the porce from the EU will be messy.
What’s bad for the European Union is also bad for the euro because if the EU can lose its most important member, the Eurozone could start losing its weakest links. This strong sense of nationalism could spillover to other countries, especially those that are struggling with euroskeptics and political fragmentation. In the long run, Brexit makes the Eurozone a more attractive destination for investments but in the near term, the uncertainty has caused Eurozone peripheral bond yields to spike, bank shares to plunge, credit default swaps to widen and the euro to weaken. Right-wing euroskeptics in the southern half of the Eurozone have already begun to call for their governments to hold referendums and if the European Union unravels, so too could the Eurozone. Spain has a general election this weekend, which will be the euro’s first test. If Podemos, the antiausterity group, emerges as the second-largest party, it would raise concerns about support for the euro and European integration. Two other forces also hang over the currency — risk aversion and possible ECB easing. In the not-so-distant past, ECB President Mario Draghi said he was ready to do “whatever it takes” to maintain financial and price stability. While the FTSE 100 dropped only 3.15%, the DAX fell 6.8% and the CAC 40 lost 8.04%. If peripheral bond yields rise further or equities experience steeper losses, the ECB could step in with more stimulus. Aside from the election, German retail sales, consumer prices and unemployment numbers are on the calendar. But all of those reports will take a back seat to risk appetite.
The U.S. dollar and Japanese yen benefitted significantly from Britain’s decision to leave the European Union but that should not surprise our readers because dollar and yen always tend to outperform in times of risk aversion. Investors flock to safety when there is uncertainty, which is also why gold was up nearly 5%. However the biggest implication of Brexit, aside from the Dow’s 500-point drop, is no rate hike from the Fed. Brexit has completely changed the discussions that the central bank is having – it’s no longer talking about if/when rates will increase but instead, if/when to provide more liquidity through additional swap lines for other central banks. In the past, Janet Yellen expressed concern about Brexit and with financial-market turbulence expected to stay, we can forget about a near-term rate hike from the Fed. In fact, Fed Fund futures are no longer pricing in a rate hike by September and instead is looking at a 12% chance of a hike before the end of the year. In other words, barring a miraculous recovery in the markets, there will be no 2016 hike, which is ultimately negative for the dollar against the yen and other higher-yielding currencies.
There has been no official acknowledgement of intervention from the Bank of Japan but the 2-minute jump during the Asian trading session from 99 to 101.50 certainly smelled of official action. The Swiss National Bank and Danish central bank on the other hand did not hide their participation. The Japanese government has verbally expressed its dissatisfaction with exchange-rate volatility but it looks like it wants to corral support from international counterparts for some type of coordinated action.
The sell-off in global markets led to broad-based weakness for the commodity currencies — but when the dust settled, the losses were under 2%. USD/CAD should be trading higher given the drop in oil prices and low yield, but the limited decline in AUD and NZD is a reflection of their superior carry. Aside from the insanity of Britain’s decision, the one certainty from the referendum is steady U.S. monetary policy. China, which is Australia’s and New Zealand’s most important trading partner won’t be as negatively impacted by Brexit as the Eurozone, or even the U.S. It will be business as usual for China, which will continue the process of shifting to a consumption-driven economy. The main drag on AUD and NZD is risk aversion, but when markets stabilize, they will be the first to recover. In the meantime, their best performance will be against the euro and British pound. Chinese manufacturing PMIs are scheduled for release next week along with New Zealand’s trade balance and Australia’s PMI manufacturing index. Canada has GDP numbers on tap. While important, these reports will still take a backseat to risk appetite.