Brexit vote triggers market mayhem

By:
Sid Verma, Solomon Teague
Published on:

The market tremors of the game-changing UK vote to leave the European Union will reverberate for years to come across global risk assets, the UK economy, banking stocks and currencies.

Brexit trader-R-600
A trader from BGC in London's Canary Wharf reacts as European stock
markets open after the UK voted to leave the European Union

As the news came in that the UK had voted to end its long-held membership of the EU, the pound collapsed by more than 10%, levels not seen since 1985.

Elsewhere, emerging market (EM) currencies saw massive declines and safe-haven currencies surged. Banks are assessing the practical significance of the Brexit vote for their operations in London, and with much depending on the terms of the exit, there is no end in sight to the uncertainty.

Market players say the violence of the sell-off, in part, reflects illiquidity and position squaring, but the Bank of England’s (BoE) promise of £250 billion to guarantee liquidity at least calmed fears for the interbank market.

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Chris Turner, ING

Chris Turner, head of FX strategy at ING, says the BoE will not defend any particular level for the pound, and it will only want to maintain liquidity.

"For the BoE, it’s all about adding liquidity and it will point to another 6m GBP LTRO next week and will also offer USD and EUR liquidity should it be necessary," he says.

However, Robert Bergqvist, chief economist at SEB, says the BoE will likely cut its key interest rate or expand its stimulative bond purchases, and might intervene in the currency market if the GBP continues to depreciate.

"The UK is suffering from both budget and current-account deficits, making it dependent on foreign capital inflows," says Bergqvist.

"Given the uncertainty resulting from the referendum outcome, the appetite of foreign investors for pound-denominated assets is likely to be limited until the effects of British withdrawal from the EU become clearer."

UBS reckons the global volatility will postpone a Fed rate hike from September to December, while the BoE will cut rates to zero and embark on asset purchases, initially in the region of £50 billion to £75 billion.

Bilal Hafeez, global head of G10 FX strategy at Nomura, reckons further declines for the pound are highly likely, reflecting short-term uncertainty around the UK leadership election and the possible terms of the UK’s exit. Sterling devaluation will rise import inflation, worth 2% to 4% of CPI, he says.

ING predicts EUR/GBP could rise to 0.90, with the speed of the move determined by how international investors, and British politicians, react. However, Turner warns the political vacuum around prime minister David Cameron’s resignation would likely expedite the pound’s losses.

The City had been almost unanimous in warning against a Brexit, and JPMorgan was first to confirm fears about London’s role as a financial centre had not been mere scaremongering. The banks is looking at relocating between 1,000 and 4,000 employees as a consequence of the result, says the bank’s CEO Jamie Dimon.

Much depends on what settlement the UK can negotiate with the rest of the EU. Elizabeth Budd, financial regulation expert at law firm Pinsent Masons, says the City will lobby for broad equivalence with EU financial regulation.

Budd says: "What we may see is a subtle divergence in regulatory requirements over time. Given the UK’s position against the bankers’ bonus cap, the assumption is that this will be one of the first EU-led initiatives to change – but it remains to be seen how this would be done, and to what extent this would impact on equivalence negotiations."

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Chris Turner, ING

The fact that countries such as the US do not have equivalence has not prevented them from conducting substantial amounts of business with EU-based firm, she adds. 

Yet none of this will mean much in the short term.

"Markets will principally be driven by beta to risk in the short term," says ING’s Turner, and as the news unfolded overnight in the UK the stand-out performer was that classic safe-haven currency, yen. However, there has been no indication the Bank of Japan will intervene, with liquidity provision seen as more likely.

Analysts assume a resurgence of a dollar-bull trend is likely, with the Fed expected to postpone its hike this year due to uncertainty and increased chance of instability. The news is likely to mean sustained gains for yen, as well as traditional safe havens such as gold and CHF.

However, the euro itself might also do well, says Turner, adding: "As long as the current environment does not lead to the EMU existential crisis, EUR should do relatively well. As was the case overnight – although falling against USD it should do better than most of European currencies, bar CHF, and higher beta G10 commodity currencies, with an exception of CAD.

"The lack of a pronounced EUR sell-off provides a degree of cushion to other European currencies, both in the G10 and EM space, and should limit their sell off compared to the 2010-2012 period of EMU existential crisis."

Compared with the 2010-2012 period, EUR/USD is cheap, notes ING, with the eurozone’s current-account position having improved and the European Central Bank seen as more credible than it was then. Market participants believe it will do whatever it takes to save the EUR, the bank adds.

Bloomberg Intelligence notes that the UK economy grew by 2.3% in 2015, losing momentum in Q1 this year as it slowed to 0.4%, from 0.6% in 4Q15.

"It’s possible that activity will decelerate further in 2Q, as uncertainty around the outcome of the EU referendum weighed on demand," it states. "Growth is likely to slow markedly in the second half of the year, but if financial stability is preserved, a recession should be avoided."