Brexit Wreck’s It-Sterling Hammered
The unfathomable became fathomable last night. UK voters decided that Great Britain would be better off opting out of the European Union (EU), the largest economy in the world, and going it alone.
FX traders and equity traders voted with their wallets. Sterling shed nearly 12% of its value against the US dollar, within 5 hours, while the FTSE 100 lost 3.15%. Conservative Party leader and Prime Minister, David Cameron, the man who created the mess, resigned.
Unfortunately, the currency and equity market damage wasn’t confined to the UK. Risk aversion spread like an Alberta-wildfire with just as devastating consequences. When the smoke cleared and the dust settled, only the US dollar and the Japanese Yen were higher than they were before the vote.
If the polls and pre-vote price action were any indication, traders were positioned for a “Remain” outcome. If true, it goes a long way in explaining the ferociousness of the US dollar rally when “Leave” won.
There is a school of thought that believes the torrential rainstorms across the UK on voting day, contributed to the “leave” victory. Whether it is true or not, the record rainfall was needed, if only to wash away the blood from losing trades.
It has only just begun
The end of the Brexit campaigning and the vote didn’t bring an end to FX volatility. Far from it. The UK’s decision to leave the European Union created new layers of market risk. There is now political uncertainty in the UK. The Prime Minister has resigned after only one year of his second term. Markets will have to deal with political in-fighting while a fractured Conservative party chooses a new leader. And then what? Would the new leader have to call an election? How does Prime Minister Boris Johnson sound?
There is more to it than that. The leader of the Scottish National Party, Nicola Sturgeon, has already said that another Independence vote is likely.
At first glance, the EU looks pretty healthy. Sure they lost the UK but they still have 27 other nations in their grasp. They may also have the upper hand in trade negotiations. The Centre for European Reform published a report in June 2014 acknowledging the difficulties that the UK may run into while seeking a new trade deal. Chief among them was that although the UK has a trade deficit with the EU, half of its deficit is with just two countries, Germany and the Netherlands. The remaining EU nations don’t run very large trade surpluses with the UK and some even have deficits. A trade deal needs the assent of the remaining 27 nations which could be hard to come by.
Article 50 is less known than Area 51
Within a month, Article 50 will be as well known as Donald Trump, at least in financial markets. Simply, put Article 50 is the formal notification to the EU of a member nations decision to withdraw. When it is triggered, all Treaties that govern membership no longer apply to Britain. The EU leadership wants Britain to activate Article 50 “as soon as possible” and Britain, with a lame duck PM probably wants a little more time.
The issue for FX markets is that inflammatory headlines or rhetoric during this process will create additional volatility. Fortunately, that issue is down the road.
The impact of the UK decision to leave the EU on the Canadian dollar will fade fairly rapidly once the initial FX adjustments have completed. There is a fear that the UK will sink into a recession which will lead to weaker global growth and by default, lower oil prices. In this scenario, USDCAD will head toward the 1.3500 area.
On the other hand, the UK/EU negotiations may just be seen as a European event and although and a side show for the rest of the world. The two-year Treaty negotiation window suggests that the major shock is over for now. That doesn’t mean that FX markets aren’t going to be exposed to additional UK/EU triggered bouts of risk aversion but that for the time being, the worst is over for FX markets
With the Brexit issue out of the way, a lot of the focus will shift back to the Fed. Does it open the door for the Fed to hike interest rates? Or is the uncertainty surrounding the Brexit negotiations the excuse that the ever cautious Janet Yellen needs to keep rates unchanged well into 2017?
For now, and throughout the summer, oil prices and the outlook for US interest rates will return to their previous status as the key factors in USDCAD direction, rather than UK politics.
By Micheal O’Neil FX Analyst