The UK is going to the polls and Citibank’s research department have updated clients with their final set of potential outcomes for the British pound, euro and dollar should the UK vote to Leave the European Union.
- Euro to pound sterling exchange rate today: 0.27% lower at 0.7658
- Pound to euro exchange rate today: 1.3058
- Pound to dollar exchange rate today: 1.4874
There has been an impressive surge in the value of the pound as the UK heads to the polls - the massive rally suggests markets believe Remain has all but won the day.
So, those who have not yet voted, don't bother showing up at the polling station.
Therein lies the problem - are markets showing a brazen overconfidence? We think so.
"With polls showing a clearly divided populace the situation remains fluid and markets could turn on a dime if news begins to leak out that Leave vote is close," warns analyst Boris Schlossberg at BK Asset Management.
As of now GBP/USD has become a highly asymmetrical bet with most of the upside already factored into the trade.
"Therefore if Remain does win the cable rally is likely to peter out at the 1.5000 level. However if Leave begins to pull ahead the pair could slide as much as 1000 points in a matter of minutes," says Schlossberg.
Citi: These are the Brexit Scenarios to Watch
The higher the pound rises, the further it must fall were a Brexit result to emerge.
Analysts at Citibank, the world’s largest foreign exchange dealer, have updated markets on their latest views concerning where the British pound could fall on a Brexit.
Citi ascribe a 40% probability of this scenario taking place, much more cautious than the betting markets.
Their research suggests UK GDP would fall by 3-4% over the next three years.
This would help initiate a sterling depreciation by around 15%. (Add on a couple of percent).
The weaker exchange rate would drive up the cost of imports, which are then passed onto consumers and as a result UK inflation is forecast to rise 3-4% in 2017-18.
Presumably, with inflation being above the Bank of England’s mandated 2% level we would see the Bank respond by raising interest rates in a more aggressive fashion than currently priced by markets.
Typically, such a response would see sterling gain in value as global investors seek to park their funds in a high-yielding environment.
This could therefore provide the necessary impetus to push sterling higher again.
But, before these longer-term scenarios, Citi believe the initial response by the Bank would be to cut interest rates and boosting quantitative easing.
That said, other foreign central banks are also expected to boost liquidity, and within this environment, likely embark on a fresh bout of easing.
EU and eurozone GDP is forecast to fall by 1-1.5% and risk aversion is likely to hurt eurozone periphery.
According to Citi, Brexit would, at least initially, boost anti-EU sentiment in the EU, and raise risk of ‘copycat’ referendums and anti-EU initiatives.
EU/Eurozone countries also equally unlikely to respond to Brexit with deeper fiscal/ political integration.
“ECB and other European CBs potentially cutting rates if FX strengthens or inflation weakens,” say Citi.
Indeed, ECB President Mario Draghi acknowledges the risks saying his central bank had “done all the preparation that is necessary”, and said there were plans to stabilise jittery markets, if the need arose.
Therefore, any counter actions from foreign central banks could well dampen the downside damage done to sterling as currencies like the euro take a hit.
What Will the Pound Do?
As mentioned, pound sterling is forecast to decline by around 15% in the event of Brexit.
The recent rally in the pound to euro exchange rate however now leaves the pair looking ‘asymmetric’ exposed to Brexit. i.e. there is more downside available on Brexit than there is upside on Remain.
“Both longer term real money and shorter term hedge funds have covered sterling shorts over the past few weeks, which means markets have already started to move towards discounting Remain winning,” say Citi.
Positioning therefore now suggests that the risks are quite asymmetric with a much sharper move likely should Brexit prevail.
The update from Citi comes amidst static market conditions, there is a sense that the market is a coiling spring.
After a largely positive week of trading it will be interesting to see how investors behave on Thursday, when the anxiety over the referendum will potentially be at its most acute.
"Bar that super-surge on Monday the markets have proved to be resistant to the kind of wild swings that could have been expected this week, a pattern that could very well extend into Thursday to create a purposefully dull day of trading as investors sit on the side-lines," says Connor Campbell, an analyst with Spreadex.
There remains a consensus that should the UK vote to Remain in the EU, GBP/USD will push above 1.50.