Volatility in the pound has risen to its highest level since the financial crisis in recent days; the pound has dived yet again against the dollar, and along with the Mexican peso is one of the world’s worst performing currencies so far this year. The smell of risk aversion is thick as we embark on another trading week, and the latest EU referendum poll has the outcome of the vote on a knife-edge.
The Sunday Times suggests that 42% of voters want to stay in the EU, with 43% looking to leave. This isn't as bad as the 10 point lead the Leave camp had last week, according to the poll in the The Independent, but it is still likely to keep investors on edge. As we well know relying on opinion polls to determine an actual outcome of a vote can be a risky business. Even so, this referendum looks like it will be close, and the market is right to be spooked.
What can we expect from the pound on June 24th?
The 24 hours after the vote is likely to see manic trading in the pound, as everyone reacts to the result. This is likely to start once the exit polls are released late on Thursday night, and trading is likely to remain brisk until we get the formal result sometime on Friday morning.
It doesn’t take a genius to expect a rebound in the pound if we vote to remain within the EU, and a further decline if we vote to leave. However, it’s worth looking at the bigger picture to try and gauge the longer-term trends post the referendum vote.
The pound loses out in the FX beauty contest:
If you look at a long-term GBP/USD chart, then you could be forgiven for thinking that the EU referendum has had little impact on the overall trend in the pound. In the last five years, the pound mostly moved sideways between 1.55-1.65, until it peaked just below 1.70 in July 2014. Since then the pound has been in a classic downtrend, which you could argue had nothing to do with the petty politics being played out in the UK right now.
However, that doesn’t mean that the referendum isn’t having a major impact on the pound, and more generally on the FX market in the short-term. The US dollar has staged an impressive rebound in recent weeks, and, interestingly, the Japanese yen is also rising. This is worth noting, we don’t often see the yen and the dollar rise at the same time, which tells us that FX traders are nervous. These nerves are causing traders to buy not one, but two safe haven currencies, even though these safe havens have seen their countries’ bond yields reach record lows in recent days.
This does not bode well for the risky end of the FX market (think commodity currencies and carry trades), and I include the pound within this risky group. After last week’s trading performance, the flight to safety is in full swing, and it’s hard to see that ending any time soon. Bonds are likely to remain in high demand for the next two weeks’ at least and we may see further record lows in bond yields in the coming days.
Blue chip debt gets government bond effect
Interestingly, the bond yields of some of the world’s largest companies have benefitted from the decline in government bonds. Apple’s (NASDAQ:AAPL) 2023 bond yield has fallen to one of its lowest levels so far this year, it and is down some 20 basis points in the last two weeks as overall risk aversion in the market has risen. While this is not an empirical analysis, it crudely suggests that investors are desperately seeking out the safest places for their money, and a huge global corporate is as safe a place as any in this environment.
Back to FX: how important is the referendum to sterling?
In the short-term, it means a lot. In the long term, a rebound on the back of a vote to remain within the EU may not materialise in any meaningful sense. The UK’s currency is coming under attack because of a number of things unrelated to the referendum including our large budget deficit and relatively lacklustre economic performance.
The referendum is merely shining a light on the UK economy, warts and all. The spotlight has revealed the UK’s economic weaknesses, which is helping to accelerate the decline in the pound and other UK-based risk assets. This should be worrying for pound bulls, as things may not return to “normal” even if we vote to remain part of the EU.
Could a vote to leave the EU be the end of the pound?
Although there are many reasons why the pound is under pressure including weak economic fundamentals, the EU referendum could cast a long shadow on the future of the pound. Let’s say that we do vote to leave the EU later this month, and in a few years decide that the economic reality of being outside the EU is so grim that we want to re-join the club. “Never”, I hear the vote leave camp say, but if we do want to re-join the EU after voting to leave then a BBC report has reminded me that we would not only have to start negotiations from scratch, but all new EU members have to sign up to the euro. So, a vote to leave the EU could be a vote to ditch the pound if life outside becomes too much to bear…
Overall, the pound’s relationship with the EU referendum is not straightforward. While in the short-term daily swings and sharp declines can be attributed to the latest opinion polls, the truth is that the pound was looking shaky before the referendum was even announced. While the referendum has taken centre stage in recent months, whatever outcome we wake up to on 24th June, the pound is still going to struggle to beat its main rivals in that FX beauty contest in the coming months.
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