FX trading during the Brexit referendum

  by Gino D’Alessio

What Would a Brexit Mean to the Forex Markets?

This article by no means wishes to sway anyone’s opinion for or against Britain leaving the EU; I’m simply going to look at what the effects could be of a referendum on the matter and the subsequent turmoil that could arise.

Investors are risk averse, including when Forex trading.

It is generally considered that investors as a broad group are risk averse. What this means is that if there are only two assets that offer the same return but with different levels of risk, an investor will always choose the less risky of the two. So it does not necessarily mean they do not accept risk, rather that they need sufficient compensation for holding a risky asset. When markets begin to look turbulent, or risk is perceived as increased, a particular asset may not be able to afford an appropriate return to compensate for this new higher level of risk.

Take a  view on the referendum; Trade the Brexit polls with IG.

The referendum itself is cause for concern, and although GDP data shows a reasonable growth rate, the Pound has been in freefall for some time. That time coincides with increased talk of a referendum, which can only create uncertainty, causing investors to flee from holding GBP or other assets denominated in Pounds. Since David Cameron made his call on Saturday 20th for a referendum to be held, the GBPUSD pair lost ground for three straight trading sessions in a row. The pound touched levels below 1.39000, which had not been seen for seven years.

Why does a Brexit matter?

As mentioned above, the referendum itself is cause for concern, this is because there are no clear conclusions as to the long term effects of Britain outside of the EU. There are only predictions that can be made based on theory and certain assumptions.

There are arguments for and against a Brexit, however, it would seem that most arguments for, are of a political nature and arguments against, are of an economic nature. However, whatever your thoughts on the matter certain facts are undeniable if it came down to Britain leaving the EU.

Currency devaluation is top of the list for most economists and analysts. It would seem likely, but it may prove a short-term consequence. In economics “short term” may mean a few years, ultimately I doubt anyone can predict the implications for Britain in 10 years time, in the event of a Brexit. HSBC has issued a report stating that the Pound could lose 20% of its value to the US Dollar due to market turmoil over the referendum. That statement is most likely to apply also to the other majors to a greater or lesser extent, such as Euro, Yen or Swiss franc.

It is certainly true that markets do not like uncertainty, and that can only weigh on the Pound from here to the referendum; if the vote leads to an exit for Britain the uncertainty will only be multiplied. The adverse effects on the currency are already being felt, and we are months away from the referendum on June 23rd. It is likely that at least in the short run a Yes vote (or polls leaning that way) would weaken the Sterling further.

Why would Sterling and other assets take a beating?

The British economy is and has been extremely dependent on imports for the past 17 years; a look at Balance of Trade shows you the UK has been a net importer over this entire period. The trade gap currently stands at £2.7 billion, and from 1955 to 2015 has averaged -£1.4 billion. Therefore, a decline in value of the Pound would be felt much more than other countries; it would make imports much more expensive, driving inflation higher. This would lead to higher interest rates and a reduction in economic activity. So the effect of a currency devaluation would also have a large impact on GDP.

When markets perceive economic growth will be impacted, and inflation will be higher, other assets will also be sold heavily. Government bonds are not generally considered a risky asset, but in time of particular market stress, they can be seen as overpriced. With inflation seen as rising, clearly the BoE will have to raise interest rates. This would make all current issues of bonds worth a bit less. Both of the factors mentioned above will also cause stock investors to look for alternative investments, stocks will also begin to look overpriced, and this asset classed is considered risky, so it is very likely this market will also suffer high levels of volatility.

The impact of a currency devaluation would only be felt if it stays in place long enough, as these matters take a lot of time to filter through. It is likely that any volatility in the markets is likely to stay around for considerable time. That said, the long-term consequences are not completely foreseeable, trade agreements could be reached, and economic activity may find new growth from exports.

There is little doubt then, that between now and June 23rd, the Forex markets (and fx trading), will be an interesting landscape, with increased volatility and changes in volume.