Will Brexit Break GBP But Make EUR?

30 June 2016, 14:34
Sherif Hasan

Brexit has hit the pound hard but the euro is doing quite well.

Here is their view, courtesy of eFXnews:

Markets have calmed down overnight with GBP and less liquid G10 currencies regaining some lost ground. At the same time, USD and JPY – arguably the biggest winners of the Brexit selloff – have pared some recent gains. We believe that the FX markets are pausing rather than turning.

Against the background of persisting Brexit fears and uncertainty, markets will continue to focus on two key questions as well:

1/ Will Brexit result is the collapse of GBP, triggering (coordinated) policy intervention before long?

and 2/ Does Brexit herald the end of the EU and even the EUR?

Starting with the first question, we believe that the risks for GBP are still on the downside as we expect portfolio outflows and earnings repatriations from the UK to intensify from here. The latest dramatic drop of the currency has already pushed FX volatility to very elevated levels, making hedging GBP-exposure quite costly and thus reducing the attractiveness of the UK as investment destination. In addition, the precipitous GBP drop will also translate in higher imported inflation before long, which will erode the real purchasing power of the UK consumer and increase the risk of economic recession. A spike in the UK headline inflation and FX volatility could force the BoE to consider rate hikes and/or outright FX market interventions to stabilize the currency. We believe that we are still well above levels in GBP TWI that may trigger BoE’s official intervention or rate hikes. The currency may have to fall significantly further (eg another 10% drop against USD and EUR) over a very short period of time to fuel concerns about financial stability.

Turning to the second question, the concern that Brexit will fuel the centrifugal forces inside the EU has been around before the EU referendum. Now that Brexit is a reality the worried investors are selling European currencies that maybe vulnerable if the EU centrifugal forces intensify The demand for EUR downside protection has intensified as well, reflected in the recent price action in EUR/USD risk reversals. The latest price action notwithstanding, we believe that a breakup of the EU and/or EUR is highly unlikely. Indeed, the results from the Spanish elections and recent opinion polls in countries like Sweden seem to point at still considerable support for the European project. In addition, it seems that the EU political elite are starting to recognise that, after years of lacklustre recovery and hardship, the electorate has grown rather weary of ever closer integration which could mean less job security and unwelcome immigration, loss of sovereignty and risks to national security. We suspect that these could strengthen calls for an overhaul of the EU, to make it a more flexible and less intrusive institution. All that could ultimately help ‘make’ EUR a better currency over time.

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