As the “Brexit” referendum draws near, market volatility is on the rise

Published: 19 June 2016
By: Tom Cleveland

June 23rd is fast approaching, and the brokerage community, both in forex and other market arenas, is bracing for a shockwave once the results of the “Brexit” referendum becomes official public knowledge. Financial markets have been anticipating this event, ever since British officials established the date back in February. Will the citizens of the UK vote to end their nation’s political and economic ties to the Euro experiment, as some have called it? Or, will they vote to remain and maintain the “status quo”? Whatever the outcome, market volatility has already begun to escalate, as uncertainty reigns.

Over the past few months, the ebbs and flows anticipating this major decision point on the future of European affairs have picked up steam, as various polls of the British populace continue to fluctuate between each side of the binary equation. Initial polls months ago favored leaving the EU, sending markets into a tizzy and forcing Pound Sterling to dip severely versus both the Dollar, as well as the Euro. When the polls shifted in the other direction, values gyrated in response, but the latest polls are now favoring an exit, a result that world leaders and local politicians have warned heavily against. Financial headlines are having a field day, but investors are at risk.

You, perhaps, have already received several email warnings from your brokers, each one well-intended and expressing caution over the impending avalanche of market volatility in the weeks ahead. Central bankers have already committed publicly to inject whatever liquidity is necessary in order to keep markets working smoothly, and investment advisors are doing their best to point out obvious opportunities for taking advantage of this situation. The Pound has been trapped in a range between 1.38 and 1.48 for the USD, hovering now at 1.42. Where it might go is open for speculation.

What is the “Brexit” referendum and why all the fuss?

It was not that long ago that a “Grexit” referendum was in the news, but that vote was about Greece and not about a fiscally sound country like Great Britain. The Greek version was more about stating dissatisfaction with the bailout process imposed upon Greek citizens. The current “Brexit “ situation has more to do with the British Parliament flexing its muscles to regain national sovereignty over pricing and labor issues, populist causes that easily ring true to a disapproving electorate. Europe has dragged its political feet on key structural and central authority reforms, creating what some have described as a ticking time bomb. If the UK leaves, then who is next? Germany?

We have heard this “contagion” talk before, but it was more about the economic malaise of Greece spreading to other weaker member states. One analyst sums up the situation as follows, “What these recent events show is the exact opposite in that countries are shifting toward a more protectionist stance and working to reclaim greater independence and sovereignty. Regardless of how the 'Brexit' vote turns out next week, what we have today more broadly is a European Union that is slowly breaking apart. If the decision is made in the U.K. to 'leave', it will only accelerate this disintegration as it will likely embolden other countries in the European Union and the Euro currency to follow the same path to the exits.” I doubt if Mario Draghi could stem this tide from happening.

The origin of the UK citizenry’s discontent may have begun as far back as 1975, when it first voted to continue participation in the European Community (Common Market). The “Yes” vote to stay was a resounding 67%, but the seeds of unrest had been planted in the Labour Party, which continued to campaign for withdrawal in the decades that followed. Pressure mounted until the European Union Referendum Act of 2015 was introduced that paved the way for a specific yes or no vote by the British populace. Prime Minister Cameron then set the actual date of June 23 for the referendum during a speech to Parliament on February 22nd of 2016. A major televised debate will be held to present both sides two days before.

What will happen if the vote is in favor of leaving the EU?

The UK never voted to give up the Pound in favor of the Euro, but only to abide by treaties that permitted it to be within the EU trading zone. British economists and bankers wished to maintain the sovereignty of the Pound, believing that it would benefit by being a “safe haven”, if and when the combined currency experiment ran into problems. Over the past several decades, however, financial ties related to trade, debt, and banking relationships have become so entwined that trying to predict the consequences of transitioning to something different is a near impossible exercise.

If there is any certainty to be found, it is that volatility will build as Thursday approaches. Investors are already positioning for a potential tsunami that will ripple through our global financial markets. Speculators are placing their bets on where to make the most gain at the lowest possible risk. Conservative investors are heading for safe havens or placing hedges to buffer any damage to existing positions. All that is being put in place now will have to be unwound at some point, which means that volatility will indeed continue for a short-term period after the vote takes place.

What will happen if the vote is “Leave”? The sun will still come up the next morning, and the world will go on about its business. The details of what will follow is laid out in Article 50 of the Lisbon Treaty, where it states, “Any member state may decide to withdraw from the Union in accordance with its own constitutional requirements”. The vote does not bind the nation to do anything, but the political pressure on Prime Minister Cameron to proceed as directed will then lead to notifications of intent to the EU, which will set another process in motion.

A recap of this process is as follows: “Once a Head of State has notified the Council of its intent to leave the EU, a negotiation period begins during which a leaving agreement is to be negotiated outlining the country's future relationship with the Union. The country seeking to leave the Union will be required to secure support from at least 72 percent of the continuing member states representing at least 65 percent of their population, as well as consent from the European Parliament.” In other words, withdrawal from the EU is not immediate. The world will have to endure two years of a long and drawn out negotiation process to produce an agreement between the UK and the EU.

What are the current polls saying about public sentiments?

As you might expect, pollsters are making hay while the sun shines, so to speak. Every news agency, tabloid, and polling consultant has tried to predict the potential outcome of the referendum several times each week for months. The latest polling has caused a stir because it suggests that a dramatic shift has occurred. During April and May, the “Yes” or “Stay” contingent seemed to have a ten-percentage point lead over the “Leave” group. The sluggishness of the global economy and the inability of political leaders to lead us back to times of prosperity have generated a great deal of anger and unrest among the citizens of many countries across the globe, the UK included. Within the last few weeks, this pent up rage has manifested in a shift in favor of withdrawal in the polls.

The “Leave” component now has a 52% share of decided voters, but therein lays the Achilles Heel of polling aficionados. There exists a hefty “Undecided” contingent in recent polling results, and the final result will hinge on how that piece is allocated when the actual voting takes place. If you combine the results of several recent surveys of the UK populace, you arrive at the following graphic:

Yes, the “Leave” group seems to have regained the advantage before election day, but a full 10% of the voting population is undecided. As one analyst, who is familiar with this sort of thing, has remarked, “Why is this important? Well, historically the proportion of undecided voters tends to (in similar such referendums) generally support the status quo. If you can't decide either way, you tend to lean towards what is a "safer" and more familiar option.”

At the end of the day, the negative reaction side of the equation has made up ground and then some, but the enormous gravity of the situation will normally tilt the final opinion of undecided voters toward the safer of the two options. Make no mistake about it: Brexit is definitely a real possibility in the scheme of things. Investors and speculators may still cash in on the big headlines to come, but caution is still the name of the game, and this new look at how poll figures can make mistakes is sobering, at least to a few followers.

Where are the potential opportunities for gain in the forex market?

Events like this Brexit vote are what fundamentally drive financial markets before, during, and after the events take place. The reaction to the latest polling results may have been on the extreme side. The UK stock market was pummeled, but it has stabilized. Investors tend to overreact, leading to excellent fading opportunities, as asset values go well past the eventual equilibrium. We can also expect a “Sell-on-the-news” type of reaction on the tail in, as well.

Many traders are shorting the “GBP/USD” pair and loading up on the “EUR/GBP” coupling. The Aussie Dollar is also drawing attention. It has a history of overreacting to negative events on the global stage. Economists are predicting a 2.5% fall in the “AUD/USD” valuation, if a “Leave” vote wins out. For those that like the more arcane bet, BitCoin has been appreciating of late, as have Gold and Silver.

Concluding Remarks

Have UK citizens lost their collective minds? One pundit of longstanding has already quipped, "Clearly we can be free, have more democracy and be better off if we ditch or cancel our EU membership, and join a Free Trade Agreement like the one people thought they were voting for in 1975."

Are the recent polls spot on? As another pundit states, “Predictions of this sort and polling generally is a notoriously inaccurate business.” Whatever the outcome, caution is advised. Batten down the hatches in case of a stormy ride, and, if you decide to speculate, be sure to protect against downside risk. Stay tuned! 

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