The Brexit Effect On Currencies
On Friday 24 June the UK woke up to the news that the country had voted to leave the European Union by a majority of almost four percentage points. After seemingly buying into the belief that the Remain camp would ultimately emerge victorious, currency markets, particularly the pound, quickly reversed course as the tide of votes showed that a Brexit was an inevitability.
By Edd Hardy
How do we leave the European Union?
Despite this momentous decision, the UK is still very much part of the European Union and will be for at least the next two years.
The process of leaving the EU was originally set out in law in the Lisbon Treaty of 2009 and dictates that the outgoing member must trigger Article 50 by announcing its intentions publically or to a meeting of EU member states. This then starts the statutory two-year negotiation period at the end of which, the outgoing member leaves permanently. David Cameron has already declared his intention to hand over the baton to the next UK prime minister to make the call on when and how this process will begin.
Where does sterling go next?
Despite markets finally having the certainty of the referendum result, it appears the UK public now know less than ever about the future of the UK’s economic standing and political establishment. The resignation of David Cameron on Friday and the crumbling of the Labour party has compounded the growing sense of uncertainty and that never bodes well for sovereign currencies. As such, it’s difficult to say where the pound will turn in the short-term without any clearer direction from Westminster or the Bank of England.
Many investment banks see further sterling weakness before the end of the year as the Bank of England’s tools to stimulate the economy (cutting interest rates and conducting further quantitative easing) weaken sterling further. There are few catalysts that could send sterling higher at this point, but given the unpredictability with which the referendum decision unfolded, it would be foolish to completely rule them out.
When will FX volatility tail off?
The next playmakers for UK markets could come from two distinctly different (and until recently, opposing) camps; the Bank of England and the Leave Campaign. The majority of economists and investment banks now expect the UK to drop into a technical recession in the final six months of this year and the response of Mark Carney and the Bank of England could stoke further currency volatility in the coming months. Markets are now pricing in a 25bps rate cut from the BoE by the end of 2016 and this could come as soon as this August’s Quarterly Inflation Report, where the BoE will not only have the opportunity to take action but also to explain and justify their decisions to the markets in depth and with the aid of a lengthy economic report.
The distinct lack of a roadmap for the UK’s exit from the EU has left the UK business community in the dark – the only timeline we know with certainty today is that the UK will likely have a new Prime Minister ahead of the Conservative Party annual conference in October this year – and the responsibility of triggering Article 50 will lie in their hands. The duties of our future prime minister will not stop at negotiating with the EU – they must also communicate far more constructively with the UK public than has been the case throughout this campaign.
How can you guard yourself from future exchange rate moves?
In short, the message then is that we can expect currency market volatility for a while to come and so any business or individual with a big and/or regular currency requirement should investigate ways to guard themselves in such an uncertain climate.
One way to do that is through a forward contract. This allows you to purchase an amount of currency for a set time in the future. The price will differ from the spot rate as the market calculates a forward rate depending on the difference in interest rates between the two countries. These products allow individuals and businesses to hedge themselves against unfavourable currency movements as far as three years in advance.
- Edd Hardy is Corporate Market Analyst of foreign exchange specialists World First.