Home What Impact will the 2016 Decision to ‘Brexit’ have on Pound (GBP) Exchange Rates?

What Impact will the 2016 Decision to ‘Brexit’ have on Pound (GBP) Exchange Rates?

Posted by on April 20th, 2016.

EU referendum

Breaking: the UK Chooses ‘Brexit’, the Pound Crashes

With a narrow majority of 51.9% to 48.1%, the ‘Leave’ referendum campaign has claimed victory, with the 17,410,742 votes in favour of a ‘Brexit’. Pound Sterling has already experienced incredible and historic volatility in the past few hours. A huge drop – the largest seen since the financial crisis – came just moments after the first results were announced around midnight, with GBP USD falling -4.4% when Sunderland registered a much larger win for ‘Leave’ than was expected. Polls released on voting day had seen traders confident of a ‘Remain’ vote, pushing GBP USD up to $1.50.

By midday on results day, losses had narrowed, with GBP USD trending down -3.6% around 1.2381 and GBP USD down -6% at 1.3686.

Continue reading for our pre-referendum forecasts for the Pound.

The UK’s EU membership referendum has already provoked serious volatility in the financial markets. To begin with, the uncertainty caused by the impending vote was primarily an issue facing Pound Sterling. However, forecasters have turned their attention to the wider economic impact and the Euro has also been weakened by speculation over the effect of a UK break from Europe. Furthermore, the International Monetary Fund (IMF) recently warned that a ‘Brexit’ risked ‘severe regional and global damage’. Given that the Federal Reserve has cited the global economic outlook as having a decisive impact on its rate hike outlook, even the US Dollar is not entirely immune to campaign trail developments.

But why is the referendum causing such uncertainty and how is this affecting GBP/EUR and GBP/USD?

Why don’t Markets like Uncertainty?

One of the main catalysts for currency movement is profit trading. This can be done by individuals, companies, or investment funds; such as those used by many pension providers. Investors buy currencies with the hope that they will gain in value, so they can sell them on for profit at a later date. This is called speculating. Traders sometimes borrow a currency that they believe is going to lose value, sell it at the going market rate and then buy it back at the lower market rate in order to repay their creditors, keeping the difference. This is known as shorting.

When looking to make a profit, the last thing a trader wants is uncertainty. A speculating trader will lose money if the currency they have chosen to back suddenly plummets in value. Meanwhile, a trader shorting a currency doesn’t want it to shoot up in value, as it will cost more for them to buy it back than they made by selling it in the first place.

Regardless of your own views on the ‘Brexit’ referendum, what is becoming clear is that no one really knows what will happen to the country after the vote. The Scottish independence referendum perfectly highlights the impact economic uncertainty can have on currency. When the first poll was released showing a lead for the supporters of independence, Sterling suffered a significant drop.

Until the key questions are answered – which they won’t be until either scenario actually unfolds – no one can predict what will happen to the economy. With demand for Pound Sterling (GBP) tied to the strength of our economy, the future of the currency is also a mystery. This isn’t good for investors, which is why they are gradually selling their Pounds and looking elsewhere for investment.

With just a few days to go before the vote, this has become even more apparent. The latest polls showing an increase in support for a ‘Brexit’ have caused jitters across the markets. UK and European stock markets have hit a three-month low, while German bond yields have gone negative – meaning investors are so eager to buy these safe investments that they are prepared to risk losing money over time to protect themselves against the volatility of other markets.

unusual investment opportunities

Pound Sterling (GBP) Weakened by Referendum Uncertainty

GBP/USD and GBP/EUR have already been significantly affected by the approaching EU referendum.

BT Group Plc. Chairman Michael Rake commented at the beginning of 2016 that, ‘There has already been some loss of investment, not huge, and there will be more if we start to get into a position where it looks serious that we might leave.’ Investors tend to welcome encouraging news for the ‘Remain’ campaign; not necessarily because they support the campaign, but because remaining in the EU will maintain the current status quo.

For example, during David Cameron’s renegotiation of the UK’s EU membership, the Pound Sterling to Euro exchange rate dropped steadily throughout the week from 1.2933 to 1.2838 as commentators speculated a deal may not be reached, while GBP/USD plummeted from 1.4438 at the start of the week to 1.3862.

As Barclay’s Plc Chairman John McFarlane explained at the time, ‘The one thing businesses can’t handle is uncertainty and this has brought a significant amount.

As soon as the first officials expressed their optimism in a positive conclusion, however, Sterling began rising, recovering to 1.2942 against the Euro. A couple of days later, when Boris Johnson shocked everyone by announcing he would campaign to leave the European Union, the Pound resumed its slump, crashing down to 1.2725. The Pound was pushed even further down, hitting 1.2645, after Michael Gove’s claimed that the reforms were not legally binding.

Since the beginning of the year, ‘Brexit’ uncertainty has been a huge driver of Pound Sterling exchange rates, pushing GBP/EUR down from 1.36 to 1.26 and GBP/USD down to 1.43 from 1.47. According to Bank of England (BoE) Governor Mark Carney, the Pound has fallen in value by -10% since November 2015.

Bank of England (BoE) Claims the EU Referendum is already Weakening the Economy

The impact of the referendum isn’t theoretical; it’s already happening. In the BoE’s latest Monetary Policy Summary, the bank suggested that ‘Brexit’ uncertainty was affecting the UK economy. The statement noted that, ‘There are some signs that uncertainty relating to the EU referendum has begun to weigh on certain areas of activity, as some decisions, including on capital expenditure and commercial property transactions, are being postponed pending the outcome of the vote. This might lead to some softening in growth during the first half of 2016.

According to S&P’s Chief Economist for Europe, the Middle East and Africa, Jean-Michel Six, the Bank of England believes the EU referendum may have already done serious damage to the UK’s prospects, regardless of the outcome. He explains, ‘The bank’s comments suggest that stay or leave, the Brexit referendum could be a lose-lose proposition: a vote to stay would lead to spikes in foreign exchange rates, hurting exports and making the pursuit of higher inflation even more uncertain. On the other hand, an exit vote could cause a run on Sterling and a spike in yields, hurting investors and consumer confidence.

The Economic Impact of a ‘Brexit’ Upon the UK

The Treasury released its forecast for the impact of a ‘Brexit’ on the 18th of April. The document, which ran to 200 pages, offered three different scenarios regarding the possible trade relationships that the UK could secure in the event of a split from the European Union. The first was that the UK would join the European Economic Area (EEA) with a deal similar to Norway’s. The second involved securing a ‘Canada-style’ trade agreement with the single market. The final, least preferable, scenario involves an agreement covered by the regulations of the World Trade Organization (WTO).

Each of the outcomes predicts that the UK will be worse off by 2030 than if it remained a part of the European Union. The figures the Treasury chose as its headline numbers were for the ‘middle ground’ of a Canada-style deal, which it claims would see GDP -6% below that of a UK which was still in the EU in 2030, equating to every UK household losing out by -£4300. Osborne warned that income tax would have to be increased by 8 pence in every Pound in order to cover the subsequent -£36 billion shortfall in tax revenue.

Under a Canada-style arrangement, the Treasury predicts a drop in trade volumes of 14-19%, though Oxford Economics predicted a drop of just-7% for a similar scenario in their post-‘Brexit’ forecast. The forecast produced by the Oxford Economics model also suggested that GDP would be -3.9% lower by 2030 after a ‘Brexit’ than if the UK remained a part of the EU, compared to the Treasury’s -6%.

The Treasury’s forecast is just one of several dovish ‘Brexit’ forecasts released by major financial institutions. IHS Global predicted that in the event of a ‘Remain’ vote UK GDP would be 2% in 2016 and 2.5% in 2017, while a ‘Brexit’ vote would see GDP fall to 1.5% this year and 1.25-1.5% in 2017. Meanwhile, HSBC’s claim that 1.5% will be knocked from the UK GDP growth rate in 2017 essentially means the economy would grow by between 0.8% and 1.3% next year. Inflation could hit 5%, well over the Bank of England’s 2% target. Citibank believes the UK will see a -4% drop in GDP compared to potential by 2019.

Morgan Stanley predicted that a ‘Leave’ vote would subject the UK to a ‘referendum shock’ that could push the economy into recession, slowing growth to 1% in 2017. If UK voters were to overwhelmingly vote in favour of remaining in the EU, Morgan Stanley predicts that the economy – and therefore Pound Sterling – would quickly recover, while a more modest ‘Remain’ vote would see a downturn around the referendum in mid-June, followed by a strong rebound by the end of 2016.

JPMorgan has calculated that the UK economy could be -3% worse-off in the long term than compared to if the UK remained in the European Union, while Societe Generale expect that UK GDP for the next decade could be -0.5% to 1% lower per year.

Should the UK stay in the EU or Leave?

What could the Impact of a ‘Brexit’ be on GBP/EUR and GBP/USD Exchange Rates?

There are just as many predictions covering the likely impact of a ‘Brexit’ upon Sterling. Interestingly, unlike most of the economic forecasts, Pound Sterling exchange rate forecasters seem to be more-or-less in agreement.

Goldman Sachs forecast a -20% drop for Pound against the US Dollar, which would take the GBP/USD exchange rate down to the 1985 region of $1.15-$1.20. GBP/EUR could drop to €0.9-€0.95. JP Morgan expects the Pound could fall to $1.33, while EUR/GBP could rise to £0.78. Deustche Bank was slightly less optimistic, predicting GBP/USD would hit $1.28 by the end of this year and $1.15 by the end of 2017. However, the bank also warned that a worse-case ‘Brexit’ scenario could see an additional -10% depreciation in ‘Cable’. A -20% drop in the value of Sterling was at the extreme end of Citi’s forecast, too. HSBC issued the same prediction of a -20% drop.

UBS released an even more dovish prediction for Pound Sterling in the event of a ‘Brexit’. According to the bank, leaving the European Union would lead to parity in the GBP/EUR exchange rate, meaning the Pound and the Euro would be of equal value.

But traders are not just concerned with the amount of loss the approaching referendum and beyond could cause Pound Sterling, but also how volatile, or unpredictable, it becomes. Measures of GBP/EUR volatility have hit a record high; 1.6% above the previous record of 25% that was seen during the global financial crisis. This means that the cost of insuring against volatility has gone up. Traders use options such as ‘futures contracts’ to ‘hedge’ against losses by fixing a price upfront; if the market moves against them (i.e. the price of buying the currency in question becomes cheaper) then they have technically lost money thanks to their obligation to buy at the higher price. When currencies are fluctuating wildly, the potential losses are bigger – but obviously so are the gains in terms of protecting against losses – which is why commentators say that the costs of insuring against volatility is higher.

The Short-Term Outlook: Projected Decline for Pound Sterling Likely

The fact that the forecasts are all so different has provoked scorn from the ‘Leave’ campaign, however, judging by the response from investors, the markets are inclined to believe at least the general sentiment behind the predictions.

As Giles Wilkes, Financial Times writer and former special advisor for Vince Cable, explained in several Tweets after the Treasury forecast: ‘There’s going to be a lot of confusion between forecasting and analysis in the next 48 hours. Put it this way: I can’t forecast what my weight will be next year. I can accept analysis that eating [a] pound of butter a day will make me much fatter. Similarly, we can’t predict the size of the economy, 2030. We do know Brexit will make it significantly smaller.

What will happen should a ‘Brexit’ occur is a complete unknown, regardless of the many predictions. It is that uncertainty which is currently weakening the Pound and with a while to go before the vote it seems that the UK asset could be in for a continued decline, at least until polling day and potentially beyond.

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