Brexit vote’s impact on the Forex and financial markets

Dear Traders,

British voters will head for the voting booth on Thursday, 23 June 2016 to decide if the UK should continue with the European Union (EU) or (Br)exit.

But what does that mean for your trading?

After all, the decision will have significant long term impact and consequences for:

1. the UK
2. the rest of Europe; and
3. even the world - as our live webinar on the matter will explain.

What's really at stake with Brexit?

Let's not beat around the bush:

...the decision to leave the EU will impact commerce, finance, politics, migration, security and even agriculture.

For British, other factors could play an important role too, such as:

1. yearning or preference for British independence; and
2. annoyance over the increasing bureaucracy of Brussels.

Ultimately, these are all important points - but the main question we'll address here, is geopolitics.

Do British voters ultimately envision Great Britain playing a role within the EU or do they prefer to promote their national interests outside of the EU framework?

Only the Brits can make that decision:

...but in the meantime, we can discuss the pros and cons of both choices for the financial markets.

And in case we miss anything in this discussion, please feel free to ask us questions directly via twitter using this hashtag - #AMBrexitFAQ

Reasons to stay

The importance and relevance of staying or leaving will obviously differ, depending on your political view.

Some arguments will be mistrusted, others highly emphasised or thrown aside.

Our role is not to endorse or reject any of the arguments - just provide an overview.

Brief arguments in favour of staying include:

1. better economic performance is expected when in the EU, with real GDP significantly lower in 2030 in both pessimistic and optimistic scenarios
2. employment stability, with 3 million jobs associated to EU trade
3. large trading volume and size with EU
4. relative stability and peace in the EU territory over recent decades
5. more influence on EU policy and direction - otherwise, the ability to shape European policy is greatly diminished
6. protection of London as the main financial center in the EU
7. danger of domino effect, where more EU countries follow the Brexit example and the EU unravels.

Reasons to leave

Brief arguments in favour of the UK leaving include:

1. freedom to control the national borders
2. restoring Britain's special legal system
3. freedom to make major savings for British consumers
4. deregulating the EU's costly bureaucracy
5. regeneration of Britain's fisheries
6. getting back to British traditions
7. no more Britain's direct membership costs of £17.4bn.

Special legislation and dropping the GBP

If the UK decides to remain in EU, it must adopt Euro and drop GBP by 2020.

Legislation in the UK will also need to be aligned with the European Union codes / legislation - this means a major rewrite.

On the flip side, if Brexit happens:

...the UK will keep the GBP and legislation…

...but will run the risk of losing its citizens with EU passports.

In turn, UK asset prices may drop and London may no longer be the financial hub of Europe.

There could be a funding deficit too, as the UK would lose access to ECB project funds.

Under Brexit, the EU citizens currently living in the UK who don't qualify for British residency or VISA requirements - won't be able to live there with just a valid EU Passport.

And guess what?

Three-quarters of EU citizens working in the UK would not meet current visa requirements for non-EU overseas workers if Britain leaves the EU.

That's a lot of people potentially leaving the UK and no easy feat for businesses to find workers to replace them.

Brexit polls

Brexit polls cause huge volatility in GBP crosses.

According to Guardian ICM, the Brexit poll currently shows a six-point lead for leaving the EU.

Impact on financial markets

The Financial Times Brexit poll (see image above) also currently shows favour for leaving over staying.

The Brexit is expected to have a huge impact on the Forex and financial markets.

Let's tackle it sector by sector.

Stock markets

Stock markets are unpredictable and they dislike uncertainty.

They move both sharply and frequently in both directions.

It is hard to predict a direct effect on stock markets, though the FTSE 100 and the FTSE 250 have both risen since Mr Cameron set Brexit vote date.

Longer-term, the impact on investments is unknown.

Share prices are dependent on corporate earnings:

...and in the event of a significant hit to GDP…

...this could have a knock-on effect to stock markets.

On the other hand, if Brexit proves positive for the economy - markets could rally.

Equities

UK exit will cause panic amongst investors worldwide, hammering equities and weakening the British pound.

Safe-haven flows will turn in the Japanese yen, sovereign debt and gold.

Equities will drop heavily, so traders should carefully watch Nikkei, Dax and SP500.

When there is a risk-off environment, the JPY appreciates because foreign flows from Japan are repatriated back to their local currency.

Yen strengthens as a result of:

1. 100% risk off sentiment
2. gold up
3. commodities prices down
4. equities down.

Bonds

The Brexit result will invariably lead to risk-off sentiment.

During such environments, flows enter the Bonds market for investor safety - including investing into Sovereign Bonds and Corporate Bonds of good credit quality.

The effect of this demand on the Bonds raises the price of the Bonds and conversely reduces their yield.

Forex, GBP, EUR, USD

Volatility is huge and daily movement of GBP crosses have highly unpredictable.

The referendum is likely to create large swings in the financial markets, not least in all the Sterling crosses.

The movement on GBP/JPY and all GBP crosses, has been massive lately.

For example, on June 13:

...GBP/JPY had 150-200 pips in 1-15 minutes...

...and that was purely caused by different poll results.

Movement has not been technical, but it has been strictly governed by different poll results.

The immediate impact of a Brexit on the GBP, is likely to lead to devaluation because of the uncertainties associated with Britain's economy going forward.

There is also likely to be a devaluation of the EUR.

Why?

Basically, Brexit signals that the currency bloc is susceptible to more EU member nations potentially exiting.

This may also mean that the US Fed is unlikely to raise rates in the immediate future, until economic impact of a Brexit is better known.

The latter may cause some temporary weakness in the USD - but it should outperform the EUR and GBP during this event.

8 tips for approaching the Brexit referendum

The news flow and market volatility are likely to increase as the referendum approaches.

The Swiss bank intervention in the Swiss Franc provided a premium example of how huge volatility can lead to losses and how important it is to protect your capital.

Here are our top tips for navigating safely through the next few weeks:

1. reduce your position size and use lower leverage, as markets may be volatile and subject to whipsawing
2. invest in risk-off currencies e.g. long trades in the JPY if it aligns with your system, using Stop Losses and realistic Target Profits
3. investing in risk-off assets such as Gold
4. consider not trading the GBP and EUR
5. consider not trading at all during these times of volatility
6. consider buying high-grade Corporate Bonds or Sovereign Bonds, as these prices increase with more demand
7. consider investing in Bitcoin, also known to appreciate during risk-off
8. choose a broker that has proven it can handle a financial storm like the Swiss bank intervention.

Our expectations

During a risk-off environment around Brexit, I expect no immediate rate hikes by the US Fed.

As a result, high-grade Bonds should experience price growth accompanied by reduced yields.

This especially concerns the EUR-denominated bonds purchased by the ECB under its Open-Market-Operations.

In addition, the Gold price may potentially increase as its a defensive asset - along with purchasing Bitcoin.

If possible, look for short trade setups on equities that align with your system.

Should there be no Brexit, risk-on sentiment may prevail and these expectations may be reversed.

Final thoughts

Despite all of the well-argumented analysis, it's virtually impossible to accurately predict the impact of Brexit.

The number of variables, factors and reactions is vast.

The simple assumption is that:

1. Brexit will cause an unfamiliar situation, which will cause higher volatility and more risks
2. a stay vote will keep things as they were and provide a more predictable environment in the short- to mid-term.

Previous referendums in Scotland on leaving the UK in 2015 and Quebec on leaving Canada in 1995 were both rejected by voters.

Will British voters follow suit?

Or are British voters willing to:

1. set aside their 40-year relationship with the EU, with all of its advantages
2. take the risk of a higher volatile environment in finance and economics; and
3. perhaps benefit from a path of independence?

Generally speaking, humans are adverse to change and our best guess is that the stay camp will win by a slim margin.

To be continued on 23 June :)

And don't forget that you can ask Brexit questions directly via Twitter using the #AMBrexitFAQ hashtag.

Cheers and safe trading,

Nenad and Chris