The Brexit vote on June 23 came as a massive shock to financial markets, especially the British pound, which fell from 1.50 to the US dollar to 1.29 within a matter of days. Across the English Channel, however, the euro took the news with remarkable equanimity, and remained firmly in the upper half of the narrow 1.04 to 1.15 to the US dollar range where it has been trading since February 2015.
The aftershocks of Britain’s decision to leave the European Union are only just beginning. The first came in late September when Prime Minister Theresa May announced a date to set Brexit in motion: March 2017, for invoking Article 50 of the European Union that deals with a member-nation wishing to leave the economic and political grouping of 28 countries, including Britain. Markets perceived the setting of a date as increasing the probability of a “hard Brexit” in the absence of an agreement to extend Britain’s current relationship with the EU after a two-year withdrawal deadline in March 2019. More aftershocks may be on the way, and the pound may not be the only one reeling from the tremors.
The euro’s stability seems almost surreal. Brexit poses a significant risk to the all EU nations, not just the UK Yet, the Euro-US dollar (EURUSD) implied volatility on 90-day options is trading at its lowest point since late 2014. Prior to concerns over Brexit heating up, options volatility on the Pound-US dollar (GBPUSD) was typically lower than that for EURUSD. While a spike in GBPUSD implied volatility relative to that of EURUSD was understandable around the time of Brexit, it’s not so obvious to us that the gap should still be so large. There might several reasons for this.
First, the UK’s negotiating position might not be as weak as it might seem. Much has been made of the fact that the UK sends 44% of its exports to the EU versus only 16% of EU exports heading to the UK (Fig.3). From that perspective, the UK position does look weak. Even worse, it’s not at all clear what could possibly replace any dip in EU demand for British goods and services. Negotiating trade agreements with former British colonies such as the US (11% of UK exports), Canada (6%), India, Australia or South Africa (1-2% each) would be time consuming and never add up to what the UK could potentially lose in trade with the EU. Also, London’s position as a financial center and the city’s role in clearing of euro trades might be in jeopardy because ‘passporting’ – the ability of a company to operate across the EU by having a base in the UK – might not be possible after Brexit without specially negotiated arrangements. However, the truth of the matter is more nuanced. Thanks to the UK’s enormous trade deficit, it imports far more from most European nations than it exports, in dollar terms (Fig.4). Moreover, while London may be inconvenienced as a financial center, talent pools are hard to move. Could any other European city or group of cities truly replace London as the continent’s financial hub?
While Dublin, Frankfurt, Luxembourg, and Paris might pick up a bit of the financial activity from London as a result of Brexit, especially on the clearing side of trading activity, we doubt that London’s entire talent pool will pick up and move to some other city. After all, where there’s a lawyer, there’s a way. London-based entities will, for all intents and purposes, control companies on the European continent that will serve as pass-through vehicles for financial products designed and launched in London.
Moreover, there will be tremendous pressure brought to bear by various commercial interests on the continent from German car makers to French farmers to play nice once the negotiations really get going. In the meantime, however, one might expect some pretty tough negotiating stances that risk pushing the pound down towards its 1985 low of 1.05 versus the US dollar.
Also, the fact that the pound has fallen so much in some respects will help to offset the negative consequences that Brexit-related uncertainty carries for investment. UK labor just became 20% less expensive from a US, European, or Japanese perspective. A relatively weaker pound should also boost inflation, helping the UK to further its deleveraging, which is already more advanced than that of the eurozone, while simultaneously boosting exports and curtailing imports. All of this should pave the way for the Bank of England (BoE) to move to tighten policy much more quickly than the European Central Bank (ECB), although we don’t see any imminent BoE tightening.
Political risks in Europe may trump those in Britain. In the UK, the two main risks are already behind it: Brexit, and the date for triggering Article 50. There is still some risk associated with the constitutional debate regarding whether or not it can be triggered by Royal prerogative or requires an Act of Parliament. Aside from that, UK political risks appear to be fairly minimal. Under the Fixed-Term Parliaments Act, the UK won’t have another election until May 2020, and Prime Minister Theresa May appears to be firmly ensconced in her new role, in part, because of the lack of any clear alternative either inside or outside of her party.
By contrast, the potential for political instability on the continent abounds. It begins with Italy’s constitutional referendum due on December 4. It looks as though the proposed reforms will be defeated, leading to the resignation of Prime Minister Matteo Renzi, and to new elections. The Dutch will hold their election on 15 March, 2017, which will be followed by the French presidential and legislative elections in April, May, and June 2017. The French elections appear almost certain to elect a new president and prime minister. Given that incumbent Francois Hollande is polling at around 12-14% in most surveys and appears unlikely to make the second round of the election, what difference does it make if he takes a tough negotiating stance or not?
Most importantly, Europe’s largest economy, Germany, will hold elections in September 2017. In the last election in 2013, Chancellor Angela Merkel’s political party (CDU/CSU) and the Social Democrats won a combined 67% of the vote. Today, they are polling just above 50%. Moreover, the anti-European Allianz fur Deutschland will likely make its entry into the Bundestag, or national parliament, leading to a much more fractured political landscape in Germany, with the strong possibility of a new chancellor.
Finally, despite two elections in the past year, the Spanish are still unable to form a governing coalition. Of course, there is always the potential for more instability from Greece as well.
As such, we think that the next aftershock of Brexit may hit the euro rather than the pound, and negative ECB rates may be adding to potential euro volatility. Paradoxically, negative interest rates may have supported the euro rather than weakened it by inadvertently tightening monetary policy and acting as a tax on the banking system that discouraged rather than encouraged more lending. While negative rates may have supported the likes of the euro and yen in the short term, the long-term consequence could be more volatility.
While we don’t think that the pound will be immune from further Brexit aftershocks, we worry that euro options traders may be whistling past the graveyard of what could be a very volatile period when EURUSD finally breaks out of its narrow trading range, which it almost certainly will at some point. Viewed from a longer-term perspective, the pound is much closer to its 1985 lows than the euro. The euro is still trading more than 30% above its September 2000 low of 0.823 versus the US dollar and more than 60% above where it would have been in 1985 had its value tracked that of the basket of currencies from which it was constituted (see Fig. 5).
On the other side of the trade, the US economy is in a much more mature stage of its recovery than the eurozone. The Federal Reserve appears likely to hike rates again in December 2016 – about a 78.5% likelihood, according to Fed Fund futures as of October 27. If the Fed does move, it could reignite the euro bear market that began in May 2014 and stalled in February 2015.
All examples in this article are hypothetical interpretations of situations and are used for explanation purposes only. The views in this article reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This article and the information herein should not be considered investment advice or the results of actual market experience.