Pound / Euro Exchange Rate Market a ‘Coiled Spring’

The pound to euro rate is likely to trend lower over coming days but huge moves are forecast in the wake of the EU referendum and market professionals are telling us that those with FX payments need to get their business finalised ahead of next Friday.

• "For now we advise against speculating on the GBP, especially from a short-term oriented angle" - Valentin Marinov @ Credit Suisse
• "Do what you need to do in the FX market before next Friday." - Lars Henriksson @ Handelsbanken
• Implied volatility in the GBP strip is now at all time highs suggesting big moves ahead

Pound sterling has broken below 1.26 at the time of writing and stock markets are falling confirming investors are defaulting back into negative mode after a short mid-week haitus.

The sell-off in GBP this June, that comes with a tightening in the EU referendum polls, is slowly taking us towards the 2016 lows of 1.2319, reached on April 7.

But, markets are telling us, almost with certainty, that big moves are coming our way.

Implied volatility for EUR/GBP on the options markets exceeded its financial crisis peak in 2008 on the 13th of June, while the same measure for GBP/USD also rose to just shy of an all-time high.

Implied volatility shows the market’s opinion of a currency pair’s potential moves in the future - in this case around the referendum.

High implied volatility suggests that markets think the EUR to GBP pair has the potential for large price swings in either direction on the outcome of the vote.

That implied volatility is surging suggests to us that the markets are more uncertain than at any time on the outcome of the EU referendum. This marries neatly with the improving odds enjoyed by the Leave vote.

Readings from the option market prices a 72% chance of GBP/USD trading anywhere between 1.32 and 1.51 on the afternoon of June 24th.

"Expect GBP to remain under pressure, with stress now spreading into the EUR and also hints that USD funding is in demand again," says Chris Turner at ING.

Those with pending foreign exchange market payments can therefore look forward to massive movements around the referendum and they stand to gain handsomely should the market go their way.

Likewise, the odds of the market moving agressively against them now almost stands at 50% owing to the tight outcome expected in the EU vote.

"Of course, extreme volatility is a distinct possibility. If a market moves against you it could gap to a completely different price level," says Adam Jepsen at Financial Spreads. "That could leave you in the hideous scenario of wiping out all the funds in your trading account."

"Worse-still is a disastrous but plausible price move that leaves you in debt," says Jepsen.

At the moment, the markets feel like a lot of tightly coiled springs.

Latest Pound/Euro Exchange Rates

	Live: 1.1455▲ + 0.1% 12 Month Best: 1.2162
*Your Bank's Retail Rate	1.1066 - 1.1111
**Independent Specialist	1.1295 - 1.134 Find out why this is a better rate

* Bank rates according to latest IMTI data.

** RationalFX dealing desk quotation.

 

Recent Falls in the Pound are Just the 'Tip of the Iceberg'

Sterling’s June tumble against the US dollar and euro “could be the tip of the iceberg” says Alex Holmes at Capital Economics.

Holmes wouldn’t be surprised if the exchange rate fell swiftly to $1.20 in the event of a Brexit, as investors temporarily shunned UK financial assets and assumed that the Bank of England would keep monetary policy looser for longer in order to offset the near-term damage to the UK economy.

The UK stock market would probably come under more pressure, too, at least in relative terms.

“For traders the biggest thing to contend with is that the result is being announced on a normal trading day – a stock market meltdown is not impossible if the vote goes against Remain. Enormous gyrations in stock, bond and currency markets is an almost certainty,” says Joe Rundle, Head of Trading at ETX Capital.

Indeed, analysts at Credit Agricole have this week written a note to their clients suggesting they steer clear of the GBP strip.

"For now we advise against speculating on the GBP, especially from a short-term oriented angle. This is due to whipsaw risk likely to rise further the closer the referendum comes," says Valentin Marinov, Head of G10 FX Strategy at Credit Agricole.

Do What You Need to Do and Get Out

The foreign exchange market seems relatively well prepared for what might be a victory for those who want to leave, looking at how the pound has been trading and the record-high prices of options.

According to Lars Henriksson, FX Strategist at Handelsbanken, beyond the initial reaction of the vote being announced, risks should be fairly symmetrical: that is, a decision to stay may strengthen the pound almost as much as a decision to leave might weaken it.

But the volatility of the first week will certainly be higher if Brexit wins.

"Be prepared for big swings in the market. The best recommendation we can make at this point is to do what you need to do in the FX market before next Friday. If the outcome is close, results may not be final until 08:30 on June 24, otherwise earlier," says Henriksson.

Could the Pound Rally on Brexit?

The default view is that the pound will rally on the event of a Remain vote, but we have also reported on many an occasion that the rally in the GBP/USD could be limited to 1.50 while the scope for a recovery in GBP/EUR is notably larger.

With regards to a Leave vote the default view is that the pound to euro exchange rate will fall, and stay low.

But even this view should be challenged.

As noted here, while sterling could stay low against the dollar, a strong recovery against the euro could transpire as markets realise that the shared currency has potentially more to lose from Brexit than does the pound.

“There’s every chance that a Brexit could lead to a breakup of the Eurozone. Greece is still looking rocky and many voters in lynchpins like Germany, France and Italy are now wavering in their support for the whole European project. If there is an Out vote, the dominos could start tumbling,” says Rundle.

Longer-Term Forecasts for GBP Strength Depend on Threadneedle Street

The default reaction by markets to a Remain or Brexit vote can carry sterling only so far; for sustained momentum to be delivered we must remember that ultimately focus will swiftly turn back to the Bank of England and how they will approach interest rates.

Will they raise rates on Remain, will they cut them on Brexit?

Market pricing for the BoE’s first hike has gone from more than 40 months away to now 20 months away.

It is still rather far into the future argue some - and this means if expectations are bought forward then risks to the British pound are to the upside.

“It is historically the norm that the BoE follows the Fed within six months with the first hike. Should history rhyme, they are well behind and further repricing will happen as risk appetite improves, supporting the GBP/USD,” says Nordea’s Augulyte.

Augulyte believes current GBP weakness and lower GBP rates are not consistent.

Governor Carney admitted recently that pressure on the GBP should the UK vote to leave the EU would reduce the need for policy stimulus.

In fact he recently said it is “not clear” whether the BoE will have to ease at all even in the case of Brexit. This could, presumably, be interpreted as being a pro-GBP statement.

Could a post-Brexit world also be a world of strong GBP? Exporters certainly will be hoping this is not the case.  

Regardless, the team at Nordea Bank are forecasting a stronger pound over coming months.

“The short-term fair value models point to levels of EUR/GBP below 0.77. Even our long-term PPP model suggests that EUR/GBP is undervalued (fair value at around 0.72). Thus in the short term the GBP should strengthen in that direction,” says Augulyte.

EUR/GBP at 0.77 equates to 1.2987 in GBP to EUR, while 0.72 = 1.3888.

Nordea stick to their previous exchange rate forecasts - GBP/USD is on the way to 1.46-1.48 in the coming few months.

The GBP/EUR is forecast towards 1.3698 by the end of 2016 by Nordea with a peak at 1.43 being reached in June 2017.

Lloyds Confirm 1.36 Base-Case Forecast

It is not just Nordea who are forecasting a return to 1.36.

Lloyds Bank, in their latest forecast update to clients, have acknowledged that the market will be shaken near term as, "the heightened uncertainty surrounding the outcome of the referendum leaves the pound especially susceptible to big swings."

Moreover, GBP/EUR sentiment may also 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.