Assumptions that the GBP/EUR will plummet following Brexit could be wrong as one analyst tells us the euro exchange rate complex will be by far the biggest loser of an UK exit from the European Union it has been argued by a prominent analyst.
“I think we could see the pound down at 1.20 against the euro, but within a matter of course, days at most, I think we could be back up nudging 1.40.”
The euro has come under pressure against the dollar over recent days as markets start to see it as being at risk of a UK exit from the European Union.
The declines comes at the same time as market funding costs in euros rise - a symptom of waning confidence in the euro.
We have seen a widening in the EUR/USD cross currency basis swap, suggesting markets are taking precautionary measures by funding in dollars, rather than euros.
It is this lack of confidence that has Nick Parsons, Head of Markets Strategy, Europe, for National Australia Bank, suggesting that the EUR/USD could fall to parity on Brexit.
It is also interesting to note that Parsons believes the pound to euro exchange rate could actually end up higher following a Brexit vote as markets quickly shift focus to the future of the European Union and the single monetary system.
Pound to Bounce Back Within Hours of Brexit
Parsons (above), tells spread betting firm IG, that some of the assumptions relied on by the likes of the UK Treasury and Bank of England on how sterling will trade following a Leave vote are wrong.
We hear a lot from the Treasury and the Bank of England, and many other learned sources, about the instability that will come to the UK economy as a result of an exit vote.
The default assumption with regards to the currency in such an event is that the pound will plummet across the board. Indeed, in their latest Quarterly Inflation Report, the Bank warned of the downside risks to sterling and the economy posed by a UK vote to Leave Europe.
And it is certainly not just the Bank and Treasury who believe the pound will suffer long term against the euro, I would say this is the default view echoed by many.
"The turmoil that we are seeing in the build-up to the Brexit vote suggests that the day after the referendum – the 24th – will be a day of extremes for the pound, whatever the outcome of the vote. If Britain votes to stay in the EU, I would expect the pound to spike to its highest level this year. If Britain were to vote out, all signs suggest a massive and immediate drop in the pound – in all likelihood sinking to its lowest point of the 21st century," says Paresh Davdra at foreign exchange brokers RationalFX.
“I am afraid it is here that our analysis differs quite markedly from the Treasury and the Bank of England,” says Parsons. "I think that the pound’s fall against the euro won’t last more than 24 hours,” says Parsons.
Parsons believes the initial reaction on a Leave vote will be simply to sell the pound indiscriminately, “I think we could see the pound down at 1.20 against the euro, but within a matter of course, days at most, I think we could be back up nudging 1.40.”
The reason for that is is if the pound leaves the euro, its more of a crisis for the euro than it is for the UK argues the NAB analyst.
“It is an existential threat for the euro which I think markets will pick on very quickly,” says Parsons.
This is actually not the first time we have heard this argument.
In 2015 we reported that analysts at Barclays were warning clients that the pound could actually advance against the euro on the event of Brexit.
"We believe that a UK vote to exit the EU may have more of a political and institutional fallout in the rest of Europe than in the UK, implying significant risks to EU and EMU stability,” says Marvin Barth at Barclays.
As such, “it is not clear to us that EURGBP is the best expression of referendum risk. Indeed, long-horizon risks in EURGBP are ambiguous, and there are clear referendum-related downside risks to EURGBP in the nearer term, in our view."
How Far Will the Pound Fall?
Against the dollar, losses are likely to be sustained, Parsons believes the pound will enter a 10% decline against the dollar and trade around 1.28-1.30.
There will also be, "a 5-6% decline against the euro immediately, simply because the first reaction is to sell the sterling.
“You shoot first, ask questions later,” says Parsons. But what is your next trade?
"You sell the euro. I think sterling will come bouncing back like a bungee chord. I think we will see a bungee jump for sterling which will end up stronger against the euro if we leave,” says Parsons.
What Happens to the Pound if the UK Votes Remain?
Like most, NAB believe the GBP will enter a bit of a relief rally in the event of the UK voting to remain a member of the European Union, the template for which is the pound's reaction to the Scottish referendum.
“We went up three and a half cents in the morning after the Remain vote in the Scottish referendum. And the morning after the vote was the high we saw for sterling for the next three months. Yes we had a relief rally, but then what?” asks Parsons.
“We may get a relief rally in sterling in the event that we remain. But let’s remember that the PM has a 17 seat majority, Europe is an issue that won’t disappear for the Conservative party.”
The view that sterling will enjoy limited upside has been echoed by analysts elsewhere. Societe Generale believe a relief rally in GBP/USD will be relatively limited as the exchange rate is already trading close to ‘fair value’ implied by interest rate differentials.
ING are in agreement, noting that sterling has only absorbed about 2% risk premium against the dollar in anticipation of a Brexit. There is thus only about 2% scope for a recovery rally.
Parsons argues further that UK economic dynamics are not strong and all those investment funds that were put on hold ahead of the referendum will not suddenly come piling back into the economy just because of the vote.
“So we are still looking at a weak and fragile economy, and there will be a dark cloud of political risk hanging over sterling and we believe the relief rally will be limited both in scale and duration,” says Parsons.
What Happens to Euro/Dollar?
Underlining just how fragile the euro exchange rate complex is heading into the vote, Parsons argues that if he is right, and the pound goes to 1.28 against the dollar, that gives you a euro-dollar at parity.
“I can divide 1.28 by 1.28,” says Parsons. “Euro / dollar at parity is what I think will happen if the UK votes to leave the EU.”
NAB believe that Brexit is as big a threat, if not more of a threat, to the single European currency than it is to sterling.
And, there will be no snap-back for EUR/USD. “I think it will retain those kind of levels.”
“What do you want to hold, I don’t want to hold euros, I don’t want to hold sterling, the dollar by default will be rising,” says Parsons.
Phenomenal implications for markets and massive economic uncertainty will be the ensuing long-term gift of Brexit.
The increasing threat of Brexit is drawing parallels to the Danish ‘No’ vote to the Maastricht Treaty in June 1992 points out Chris Turner at ING.
This delivered a serious shock to the FX and bond market convergence of EMU aspirants (including the UK) and generated a surge in the DEM against the rest of the Europe and the Dollar, as short DEM positions were unwound.
It took over a year for markets to settle from that shock and destroyed fixed arrangements for both GBP and SEK.
"While Brexit is not our base case, the much closer vote than expected is starting to see that EMU convergence questioned in the bond market, where peripheral Eurozone and CE4 bond markets are starting to under-perform. With over a week to go, look for EUR/JPY and EUR/CHF to stay under pressure," says Turner.
And assuming the Fed does not introduce a new dovish line of argumentation today, EUR/USD should stay pressured too.
"We have a slight bias to the 1.1120 area today in EUR/USD," says Turner.
But, longer-term, there are clearly notable risks growing for the euro.
Recovery in GBP/EUR Towards Year-End
We have meanwhile heard from Lloyds Bank that they expect the pound to ultimately recover against the euro back to 1.36.
Forecasters acknowledge that GBP/EUR sentiment may be impacted over the coming weeks by shifting expectations over the relative monetary policy outlooks in the UK and the euro zone, with the possibility of additional ECB stimulus later this year.
"By convention, all of our forecasts are based on the assumption that UK government policy towards EU membership remains unchanged. Under this premise, we look for GBP/EUR to end the year around 1.36," say Lloyds.