Barclays argue the markets’ focus on EURGBP in the Brexit debate is misplaced and the pair risks a downside correction.
The UK’s referendum on continued membership of the European Union presents enough uncertainty to justify a sharply lower British pound.
Goldman Sachs have suggested sterling could fall 20% should the UK vote to leave the European Union while ABN Amro, for example, are warning on the GBP/USD exchange rate falling to 1.25 in 2016 due to Brexit risks.
As always with such unprecedented events, the expected impact on the currency market is an evolving one and up for debate.
And the debate is certainly picking up.
For instance ING argue that markets are overly pessimistic on sterling at this point in time and there is therefore the prospect of a short-term recovery in February.
Barclays have also suggested markets are wrong on their approach to Brexit. In a note to clients, entitled ‘EU Referendum: The Clue is in the Name’ analysts at the British bank say they believe markets may misjudge the UK’s referendum on EU membership in three dimensions:
1) the breadth of its potential impact as a broader European or global risk;
2) the likelihood of a ‘Leave’ vote, particularly the later the date of the referendum; and
3) the likely timing of the referendum and the importance of risk events that will precede it.
The view at Barclays is informed by two key aspects of the UK’s vote that they believe are underappreciated:
1) it is a European issue, and hence of global importance, not just a ‘UK’ or ‘GBP’ issue; and
2) its outcome is driven by political economy, not just economic impact.
“Immigration is set to be the key ‘wildcard’ driving the referendum’s likely outcome and, with procedural constraints, timing. Because immigration also is the top political issue in the rest of the EU, and a UK exit would set an unwelcome precedent, the EU referendum is at least as big a risk to EU and EMU stability as it is to the UK economy; ie, the clue is in the name,” says Marvin Barth, a foreign exchange researcher at Barclays.
In 20 of 28 EU members, immigration was reported as the most important issue facing the EU, by an average margin of 6 percentage points.
According to the European Council’s Eurobarometer survey, for the EU as a whole, immigration has risen to eclipse all other issues, including unemployment and the economy:
“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 Barth.
Can you see the road Barclays are taking us down? If the EU stands to lose from a UK exit, then so too does the euro.
Timing the Referendum is Key
Immigration’s clear impact on polls appears to explain Prime Minister Cameron’s June referendum push – and increasing receptivity from his European counterparts – before migration flows hit a seasonal peak.
A June referendum appears possible only with a deal at the February EU Summit being reached, making February a key risk event in the evolution of this story.
“Our assessment does not appear to be shared by markets, judging by pricing in FX, rates and credit. We see the greatest differences to our view, and hence opportunities, in FX. The referendum is a risk for rates and credit investors, but the implications, a priori, are less clear,” says Barth.
If the Prime Minster is to succeed in keeping the UK in the EU, recent migration patterns and voters’ reactions to them suggest that a June referendum is a high priority.
Barclays say that a vote any later risks another surge in voters’ intentions to ‘Leave’ should migrant flows again dominate the summer news flow.
“Indeed, based on last year’s monthly pattern, the worst possible timing would be in September or October. Even a later referendum, eg, November, December, or into 2017, poses a greater risk of a UK exit, given the apparent persistence of the impact of the migration crisis on voter intentions,” says Barth.
What This Means for the Euro v Pound Exchange Rate
Since the December European Central Bank (ECB) meeting EURGBP has been among the best performing currency pairs as market attention shifted from ECB risks to the EU referendum.
EURGBP is up about 5% in the post December meeting period. In contrast, EURUSD has been roughly flat over the same period.
Barclays argue the markets’ focus on EURGBP is misplaced and risks a correction should there be a positive outcome at the February EU Summit.
“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,” says Barth.
Furthermore, far clearer are the directional implications for European currencies as a block versus both the USD and the JPY.
How Will the Euro v Pound Exchange Rate React to an Out Vote?
The initial reaction to a UK exit will likely be EURGBP moving higher, given the market’s bias.
But, further out the exchange rate reaction will depend on how Europe reacts.
If the EU remains politically stable, it is argued by researchers that focus will shift to the reaction of Scottish voters, who would likely ask for another referendum on union with the UK.
“The combination of a UK exit with European stability may increase the risk of Scottish independence – though that is far from certain with Brent at $30 per barrel – an event that would put still further upward pressure on EURGBP, and perhaps weigh on EURUSD, USDJPY and EURCHF,” say Barclays.
However, if politics in the EU turned for the worse - which is the preferred scenario at Barclays - the UK may be seen as a safe haven from those risks, reversing EURGBP’s appreciation and putting significant downward pressure on EURUSD, EURJPY, and USDJPY.
“In that environment, Scottish voters could be even less inclined to leave the relative safety of the UK for an increasingly uncertain EU, further reversing EURGBP appreciation. In this EU outcome, we believe EURCHF would likely experience high volatility, in the face of significant downside in reaction to severe uncertainty about both the UK and EMU, but this could precipitate the Swiss National Bank’s ‘Nuclear Option’ to reverse CHF strength,” says Barth.
The longer-horizon direction of EURGBP is therefore ambiguous.
However, on a shorter horizon, given how much it has appreciated, “EURGBP is at significant risk of a pullback in the event of a positive outcome at the February EU Summit that lowers the perceived risk of a UK exit,” say Barclays.
For longer horizon risks, short GBP and EUR versus either the USD or JPY look like much cleaner spot FX expressions of referendum risks suggest Barclays.