How to Trade the Looming Brexit Vote

With under two weeks until the Brexit vote, a poll by the Independent (UK) has signaled a potential massive shift in favor of a vote for the United Kingdom to leave the European Union on June 23. Before this new poll, public support for an exit vote was mixed with many polls indicating a slight edge in favor of the UK remaining within the EU. This most recent revelation is certain to keep investors fleeing sterling (GBP), which has already been pummeled the last two weeks (see chart, click to zoom).

Chart: GBP from Monday, May 30, 2016 to Friday, June 10, 2016.

Rapid investor flight from sterling has been a recent pattern, most noticeably leading up to the Scottish succession referendum and during the first half of 2016 as Brexit talk began to take center stage. Given the already challenging economic outlook the UK faces, with declining industrial output and no sign that the Bank of England is comfortable to raise rates anytime soon, investors cannot be happy that the UK has lurched from one political integration crisis to the next over the past two years. Uncertainty dampens demand for sterling (GBP) because investors wish to avoid excessive risk exposure. Safe haven assets, notably US Treasurys and francs (CHF), continue to enjoy skittish capital faced with economic uncertainty.

The next 13 days are likely to see further declines for sterling (GBP) as heated talk from Brit politicos such as Michael Gove and Boris Johnson, and the potential emergence of further polling data like the latest from the Independent, take center stage. This issue of the EU referendum is already front and center in the mind of most UK and commonwealth residents and the days leading up to the vote are certain to be chalk full of public deliberation. Given that the two most prominent political leaders of the leave and remain camps are Boris Johnson and David Cameron, respectively, neither side has yet to discover their cause's public rhetorical champion. As such, UK public opinion on a potential Brexit may still have many significant swings left before the vote.

For all the cross-talk, a Brexit is disadvantageous for the UK, European and global economies. Setting aside the clear harm of shrinking trade flow, small and medium sized UK businesses will face severe new challenges. Today, it is common for small firms to be as internationally-minded as large multinationals as they consider labor resources, suppliers and markets to sell in. Membership in the EU, as frustrating as it may be, has helped UK business thrive due to the predictable opportunity to access the world's largest trade bloc.

Those that doubt the economic disadvantage prediction make two replies. First, a vote to Brexit does not immediately change the economic status quo, as it prompts the UK to begin the process of notifying EU members that it will be leaving the group. This notification will stand in place for nearly two years before any substantial economic ties are severed. Second, there is a widespread belief that the UK will be able to quickly negotiate a series of bilateral free trade agreements with the important and significant members of Europe to retain access to markets and resources. Yet, as likely as it is that many European nations will share a mutual desire to maintain free trade terms, it is unlikely that suitable replacements to the EU free trade zone agreement will come easily or quickly. The politics of trade agreements are difficult and the EU framework, as taken for granted as it is, has allowed European capitals to grow rusty in this area of diplomacy. Furthermore, it is impossible to predict what new pressure Europe will face two years. No one should be confident that new trade agreements will soon pop into reality.

Forex Currency Symbols
Currency symbols for United Kingdom Pound Sterling, United States Dollar, and European Union Euro.

Even if Euro-skeptics are correct that the UK will prosper without membership in the EU, the tone of economic uncertainty that will rule the transition is substantial and makes the looming potential Brexit too risky to be worthwhile. Beyond the UK, the risk to the rest of Europe is significant as well. Brexit will cast further doubt on EU cohesion and may prompt swift consideration of exit by other members, including Inner Six nations France and Italy. Even if Brexit does not begin a domino effect that rends the EU, the loud rejection of integration it represents will heavily burden the European project. As Europe reels from the migrant crisis and violent pressure from an economically flailing but militarily and politically assertive Russia, it's hard to see how any liberal nations benefit from reversals of integration.

Strategy notes:

  1. Sterling (GBP) gets pounded whenever Brexit talks dominate the news. The next 13 days will be volatile and sterling will likely fall further.
  2. Despite the great punishment sterling (GBP) has taken thus far, expect further declines if the UK votes "yes" to Brexit. Further uncertainty will depress demand for sterling (GBP). Such declines may be deep and prolonged if UK negotiators don't achieve immediate initial-commitments about trade agreements.
  3. If the UK votes "no" to Brexit, sterling (GBP) will rally because uncertainty about the UK's economic future will be put to rest.
  4. Until recently, the most likely outcome of the vote was "no" to Brexit but new polling moves the outcome to even money. EU Integration is popular in London and Liverpool but sentiment changes once one leaves the city districts.
  5. In terms of currency pairings, both the dollar (USD) and euro (EUR) have tracked sterling downward at similar rates. As the uncertainties of a Brexit grow large over Europe, the dollar will come out strongest of the three. Selling cable (GBP/USD) will have greater returns than buying the euro pound (EUR/GBP) over the next two weeks.

Disclosure: No position.

Disclaimer: I hope this analysis helps you to be more informed and make money. The opinions in this document are for informational and educational purposes only and are not a recommendation to buy or sell any assets mentioned or to solicit transactions or clients. Do not act upon any investment information without consulting an investment adviser.

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