Brexit lets the genie out of the bottle, expect more market volatility

Fear in the global markets is not primarily being driven by the potential impact Brexit will have on the UK economy, but on the precedent it sets for other key political events over the next 12 months or more. The one certainty is that there will be further market volatility.

The UK referendum has reminded traders how violently markets can react when a known event goes completely against expectations, with market participants positioned for a singular outcome. It taught traders about how markets react when the participants are largely unschooled in political events and the knock-on effects of a political movement plays into economics, confidence and the perception of a final central bank response.

The wash-up is not that traders globally are specifically concerned about a headwind to UK growth and the impact that may have on its trading partners. But with a number of political events in Europe and the US over the coming 12 months, the UK leaving the EU sets a precedent and a road map for European countries who are seeing a rise in anti-European sentiment to use as case study for life outside the union. This is before we even look at the ramifications of potential consistent US dollar and Japanese yen inflows and the negative consequences that would have on growth and inflation.

As Nigel Farage detailed to the European Parliament, ‘Britain won’t be the last country to leave the EU’. While Mr Farage’s comments are symbolic, it puts a strong focus on presidential elections in the US on 8 November and more notably France in April (first round) and May (second round) and general elections in Holland in March and Germany in late September 2017.

If we look at the various polls through May to June there is a strong anti-EU stance in Holland and France, while the support for the Alternative for Germany (Afd) party is always one to watch. To provide perspective, recent research from the PEW Institute showed 61% of those polled in France disapproved of the EU. Germans were more nuanced, with the disapproval rating at 48%, although this was the same as the UK pre-referendum and we know how the British voted.  

If the UK has set a precedent, then these other EU countries represent something far more concerning, because any break-up involving these countries would not just mean a future outside of the ‘single market’, but out of the European Monetary Union (EMU). If Greece caused massive bouts of volatility in periods through the last five years then the political event risk in front of us over the next 15 months could make the volatility recently seen look fairly sanguine. 

The UK needs a strong government

Much attention has been placed on when the UK government triggers Article 50, starting the process of determining the terms of the UK’s divorce from the EU. There seems little doubt that despite certain EU members pushing for the UK government to start this process sooner, it is in the interest of the UK to have the highest certainty around its exit conditions. Therefore, a protracted and drawn out process is highly likely with relations between the UK and EU further souring. It all provides tail winds to the anti-EU protest parties.

As an Englishman who resides on the other side of the world, the political situation in the UK seems incredible, with the Conservative party determining a new party leader and a revolt underway in the Labour party, with Jeremy Corbyn refusing to step down despite a huge vote of no confidence. The UK needs political stability to even think about entering negotiations with the EU and this is important for global markets because if the UK thrives outside of the EU it simply provides even further political ammunition to the anti-European parties.

Financial markets have been savaged since Friday, largely as a result of the unknown and the idea of future political contagion across the wider Euro region. The UK vote has unmasked fragility once again in the UK, and more specifically the European banking sector, leading to the speculation the Italian government will channel €40 billion into the banking system, as well as guaranteeing Italian bank bonds. 

It has led to interest rate markets pricing in a 20% chance of a rate cut from the Federal Reserve this year, while the prospect of the Bank of Japan, European Central Bank, Reserve Bank of Australia and Bank of England either cutting rates or adding to existing Quantitative Easing programs has increased. It’s no surprise therefore to see implied financial market volatility such as the volatility index (which measures expected volatility on the S&P 500) falling quite spectacularly. This won’t last though in my opinion and this is a traders’ market and those who hold an understanding of reading price action gain a distinct advantage.     

The short-term trade

Looking into the immediate future I feel there could be more upside in equity markets, and I am specifically keen to watch the S&P 500 and how price acts around 2042 (the 38.2% retracement of the sell-off from 2127). A closing break through 2042 would drive a move into 2075-2080. On the four-hour chart the oscillators are rolling over though, which does throw some headwinds around whether the index reaches 2042 and it seems logical to look more intently at short positions (with a stop above 2042) and joining the money flow should the sellers wrestle back control.

The DAX is eyeing a move into 9667 (the 38.2% retracement of the sell-off from 10,481), where I feel traders will look to fade the rally (stops above 9850). 

The US dollar index is sitting on key support as we can see in the daily chart. This looks particularly bullish, with price consolidating above the May swing high. If we take the view that the US dollar is pivotal to US inflation expectations and the odds of a potential global recession (which some investment banks suggest is around 40% probability), then a renewed push higher here would be a headwind for other markets. 

IN_GBPUSD – Such is the volatility in cable that I have taken the time frame to two hours. Price action looks quite unconvincing right now, but a break through $1.3400 puts the pair on a path to test $1.3600 (blue horizontal line) and even the key failure point of $1.3911 from 24 June. This seems like a hard slog, but given the implied volatility in cable it isn’t. Selling into $1.3911 is the high conviction trade, although I am watching to see if the pair rolls over from current levels and again I would look to follow the money flow, adding to shorts on a break of the recent low of $1.3121.

The UK has opened a can of worms by leaving the EU and while there is a huge political mess that needs to be worked through, the bigger issue is that market participants have politics firmly on their radar. Central banks have far less ammunition than in prior cycles to address potential volatility and corporate leverage has only increased.

Further asset purchases from Japan only speeds up the inevitable and QE4 from the US Federal Reserve would have minimal impact given fixed income pricing. A genuinely worrying seed has been sown and the prospect of incredible volatility over the coming year is now a major consideration and although governments will work together to try and mitigate these actions the will of the people will be the deciding factor.

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