Posted on: 20 June 2016, by: Boris & Kathy, category: Market Review
For the past 6 months investors have been waiting with bated breath for the UK’s EU referendum. We are now less than 4 days to the vote and no closer to clear majority. Last week’s tragic killing of Jo Cox, the UK member of Parliament shows how the amount of passion and anger around the issue can radicalize extreme voters. It was the closeness of the votes that led both sides to escalate their language ahead of referendum but even with the murder of this pro-EU British campaigner and ensuing sterling recovery, bookies still put the odds of Brexit at just under 40%. These numbers show that the Leave campaign has successfully tapped into the country’s growing frustration with immigration but Brexit has significant consequences that will rip the British pound and the European Union apart. It is estimated that sterling will fall as much as 10% or approximately 1400 pips and the economy would shrink by more than 3% over the next 3 years. In fact her Majesty’s Treasury estimates a 7.5% contraction over 15 years. These projections may be over exaggerated but the consequences are significant on both a short and long term basis. S&P warned that Britain could lose its AAA rating and the seamlessly renegotiated trade pacts may not come easily as EU nations retaliate. Multinational corporations will look to move its European headquarters from London to Frankfurt or another major hub on the continent. While a Britain free from the EU would be able to set its own regulations, it is foolish to think that it won’t be influenced by its desire to cooperate with a region that takes 45% of British exports.
As currency traders, our focus is on the short to medium term market impact of the EU referendum. First let's start with pre-Brexit trading – while many traders believe that the high degree of uncertainty will drive sterling to trade lower in the days ahead of the vote, we need to warn our readers about the risk of a short squeeze. Sterling has fallen significantly over the past month and with most forex brokers raising their margin requirements ahead of the referendum, it creates strong motivation for traders to take profits ahead of such a significant event risk. The Swiss National Bank’s decision to abandon their EUR/CHF peg is still fresh on everyone’s minds and the potential for a more than 400-pip swing in either direction may be too much for leveraged traders.
On the day of the referendum, the votes will trickle in slowly. At some point, a majority will start to form and if you’re following the poll results on twitter and have fast fingers, you may be able to join the move for 100 to 200-pip profit. The gains will be sustained and likely to turn into a steady 4 to 5% recovery for sterling if Britain decides to remain in the European Union. However if they decide to Leave trading will be very messy. A Leave vote could trigger a 4 to 6% knee jerk decline in sterling but watch for a significant V shaped recovery if lawmakers try to calm the markets by saying that all remains the same until the terms of Brexit are negotiated – which could take months or possibly even years. But any intraday recovery will be short-lived as investors view Brexit as a major mistake that will cost Britain its position as the region’s financial and corporate hub.
With all of this in mind, our recommendation is for all retail traders to be flat ahead of the referendum. There are plenty of trading opportunities on a day to day basis and given the degree of uncertainty, potential volatility and the risk of stops being filled far beyond your levels, it's just not wise to be heavily exposed on the day of the referendum.
With the exception of USD/JPY, it was relatively benign week for the U.S. dollar. Most U.S. economic reports including retail sales surprised to upside but rallies were limited by Fed Chair Janet Yellen’s cautious outlook for the U.S. economy. This left the greenback unchanged against most major currencies including the euro. However USD/JPY was a big story as it faced heavy selling on the back of the Fed’s dovishness, BoJ’s decision to keep monetary policy steady and risk aversion. The pair dropped below 104, to its lowest level since 2014. The FOMC rate decision actually had very limited impact on USD/JPY. The currency pair had been sliding lower ahead of the Fed meeting and only added minor losses following the announcement. In her speech the week prior, Janet Yellen hinted that they needed to tread carefully after the abysmal May non-farm payrolls report and this gave investors the opportunity to position for Wednesday’s announcement. Aside from leaving rates unchanged, the Fed expressed concerns about labour market activity, the weakness in business investment and spending along with the global economy. They also lowered their 2016 and 2017 GDP forecasts. Most importantly, Yellen refrained from saying that rates would rise in the coming months and the dot plot forecast dropped to 11-6 members favouring 2 hikes this year versus 16 to 1 in March. We believe that the Fed needs to see at least 2 strong labour market reports before raising rates again, which means the next realistic chance of a rate hike will be in September. The greatest part of the USD/JPY decline came on the heels of the Bank of Japan rate decision. While we did not believe the BoJ would ease monetary policy, apparently many investors had hoped for a move or dovish commentary. When the central bank failed to deliver, they sent the Yen soaring against all major currencies. Clearly the move backfired as Japanese officials came out in force trying to talk down the currency, even expressing G7 coordination but at this stage no one will act before the U.K. referendum.
How far USD/JPY falls now hinges on the Brexit vote and its impact on risk appetite. If Britain decides to leave the European Union, U.K. assets won’t be the only ones to respond negatively. Markets will fall across the globe and risk aversion will send USD/JPY significantly lower. If they decide to stay then we’ve probably seen the near term bottom in USD/JPY.
It was a dull week for EUR/USD, which spent the entire time trading between a narrow 1.1175 and 1.1300 range but as the Brexit vote looms we can’t help but think that the EU referendum is a lose-lose for the euro. If Britain decides to stay in the European Union, all of the traders who shorted sterling versus the euro will unwind their trades and the buying back of pounds versus the euro could drive EUR/USD lower. Ultimately a vote to "Remain" will be positive for risk appetite and the EUR/USD especially because it diminishes the need for additional ECB easing but we could see a period of weakness before recovery. A decision to "Leave" poses greater problems for EUR/USD because the fracture in Europe immediately raises the question of who will leave next. It will lead to broad based risk aversion that will translate into significant losses for EUR/USD. So while there are a number of important Eurozone economic reports scheduled for release next week including Eurozone PMIs and German IFO report, Brexit trumps everything.
There was very little change in the Australian and New Zealand dollar’s performance last week versus the greenback despite slightly weaker Australian data and much stronger than expected New Zealand data. Unsurprisingly, this did lead to AUD/NZD weakness. The Canadian dollar on the other hand traded lower as oil prices remained below $50 a barrel. In the coming week, all 3 commodity currencies will trade exclusively on the market’s risk appetite and the direction of the U.S. dollar. The minutes from the Reserve Bank of Australia’s monetary policy meeting is important but the last time they met, they simply expressed comfort with the current level of monetary policy. Canada’s retail sales report can also be very market moving but coming a day before the referendum, any reaction to CAD data will be short-lived. The focus for the Canadian dollar has generally been on oil but this week oil will be determined by the path of the U.S. dollar. Commodity currencies are risk currencies, which means they will rally if Britain decides to remain in the European Union and they will fall hard if they decide to leave.
It will be an unusually active week and we wish good to luck to all.
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