By Enrique Diaz-Alvarez and Matthew Ryan at Ebury
Sterling rebounded from its recent multi-year lows in the past three months as concerns regarding a possible UK exit from the European Union at this month’s referendum receded.
However, volatility remains very high in the lead up to the referendum and every new poll released causes sharp swings in the markets.
The Pound plunged by 8% in trade-weighted terms around the turn of the year to its weakest position in seven years against the US Dollar, at a time when the polls suggested the outcome of the referendum could be too close to call.
However, dwindling support for a Brexit in most of the recent polls has alleviated some of the uncertainty and provided decent support for the UK currency.
Sterling last month rallied to its strongest position against the Euro since February and has now recovered around half of its losses against the US Dollar since the beginning of December (Figure 1).
Last month the Bank of England also stepped up its warnings on the impact of a Brexit. The Bank suggested that a vote to leave could cause a sharp depreciation in Sterling, increase unemployment and possibly tip the UK economy into a recession.
Bookmakers implied probability of a Brexit, seen by economists as a good barometer of the chances of a UK exit, fell in May to just 20%, although it has rebounded recently to just under 30%.
We think the best indicator is provided by the Number Cruncher Probability score, which attempts to take into account the biases of each poll. This score now sees the likelihood of Brexit at just over 24%.
However, uncertainty regarding the outcome of the referendum remains the single biggest risk to UK businesses . One month implied volatility in Sterling has subsequently soared, and is now at its highest level since 2009 and well above that of EUR/USD (Figure 2).
The same measure for EUR/GBP is also at its highest level in seven years, with volatility in both pairs likely to remain very high until after the referendum.
In an attempt to avoid any adverse moves in the Pound in the event of a Brexit, businesses in the UK have continued to hedge their Sterling exposure in the lead-up to the referendum on 23 June.
A recent poll by banking researchers East & Partners showed that four-fifths of Britain’s major companies had taken steps to hedge the currency risk of an EU exit.
The lack of historical precedent makes it very difficult to estimate the short term impact of a Brexit result on Sterling.
The consensus of market strategies would suggest an immediate drop of around 10%. This is reasonable in our view, though we emphasise that we expect a ‘remain’ result.
Despite the closeness of the polls, we’re still of the opinion that Britain will vote to remain a member of the European Union at this month’s EU referendum.
As was the case in the referendum on Scottish independence, there is evidence that maintaining the status quo attracts a significant fraction of the undecided vote.
In the event of a ‘remain’ vote, and based on the probabilities priced in the markets for an exit, we would expect a rally in the Pound of roughly 3-4% against the US Dollar.
The reaction of the EUR/USD rate to the outcome of the referendum is even harder to predict. This exchange rate has moved about 20% as much as GBP/USD in reaction to the most recent poll releases.
Extrapolating these moves, we would expect EUR/USD to drop 2% in the event of a Brexit and rally by 0.5% - 1% if, as we expect, the ‘remain’ campaign succeeds on the day.
In our view a ‘remain’ vote should also enable the Bank of England to hike UK interest rates for the first time since the financial crisis in the fourth quarter of the year, allowing the Pound to keep pace with US Dollar appreciation and end the year significantly higher versus the Euro.
Conversely a surprise vote to leave would also ramp up pressure on the Bank of England to announce an immediate interest rate cut, with the timing of a hike pushed firmly into the distant future.