Aside from the mid-June meetings of the monetary policy makers at the US Federal Reserve and the Bank of Japan (BoJ), the ‘must-watch’ event this month will be the UK referendum on continued EU membership on 23 June.
Interestingly, Fed chair Janet Yellen is also scheduled to speak two days before the so called ‘Brexit’ referendum in her two day semi-annual monetary policy review on 21 June. This is sooner than the usual July testimony, and seems a function of the Republican (18-21 July) and Democratic (25-28 July) presidential nomination conventions.
Investors now have to navigate portfolios through the meeting of the Fed’s Federal Open Market Committee, the BoJ meeting, a German Court ruling on the legitimacy of the ECB’s bond-buying programme, officially called the Outright Monetary Transaction program, the UK referendum, the Spanish election and Janet Yellen’s testimony, all in the space of 12 days. It promises to be a period where news headlines will throw markets around and while the probability is these events don’t cause a significantly negative impact, how often have markets been wrong in the lead up to key events this year?
There will also be some focus on the take-up by European banks for the ECB’s liquidity operations as part of the TLTRO II (targeted longer-term refinancing operation) on 24 June. A strong take-up of funds would increase the size of the ECB’s balance sheet and would be seen as a positive for European equities on the idea that the banks could use this liquidity to try and extend money into the real economy. Markets generally like excess liquidity.
The event which has the premise to promote the greatest degree of market volatility is the UK referendum, although if the bookies, and not the latest opinion polls, are correct then we don’t have much to be concerned with. The fact that so many key organisations and world leaders have warned about the dangers of ‘Brexit’ has made traders believe this is a genuine global event risk. The threat of such uncertainty should lead to a reduction in confidence, a sharply weaker pound and a fall in Foreign Direct Investment (FDI) and this has all been well documented. Talk of an economic collapse from the likes of the OECD have been portrayed, suggesting we could see a hit of up to 5% to economic growth if a Brexit does occur.
The impact of a ‘Brexit’ will ripple through financial markets globally as traders and investors sell first and ask questions later, and this will not be contained in just UK and European assets. In fact one of the best trades (other than generically selling GBP) will be short USD/JPY, as there is little doubt that the implied probability of a hike from the Fed at the September FOMC meeting will drop from around 80% to less than 30%. The JPY, US treasuries (quoted as 10-Jaar T-Note Decimalised on the IG platform) and precious metals will be the assets to be long. Of course, pure equity index market volatility measures such as the EU and US volatility index will likely move significantly higher and it won’t be a one-day affair, so this is another tradeable instrument that traders could look at in the event of a ‘leave’ vote.
Traders ramp up ‘Brexit’ hedges
One of the more interesting dynamics seen in the last week has been a change in IG’s UK referendum binary, where the implied probability of UK voters siding with the ‘Remain’ camp has fallen modestly from 80% to 75%. However, it’s interesting to see that traders have really started to increase referendum hedges again and this can be seen clearly through the options market. Our own flow has been quite nuanced with 61% of open EUR/GBP positions currently held on the long side.
If we look at one-month implied volatility in EUR/GBP and GBP/USD we can see that both have sky rocketed by over 70% from last week, to stand at the highest levels since 2008 and 2009 respectively. GBP/USD risk reversals (which measure the cost of out-of-the-money call options relative to puts) have collapsed from -0.94 to currently stand -6.2, showing the cost to hedge against downside in the pound has become very expensive.
Another interesting dynamic is that while the referendum polls have been influential in pushing GBP/USD into $1.4400, for the last 12 months or so the strongest correlation has actually been with oil. That correlation is now breaking down. EUR/GBP has rallied from £0.7600 to £0.7770, but I wouldn’t be exposing portfolios too greatly to EUR assets, despite an improvement in European data.
Clearly the worst possible implication of any vote to ‘Brexit’ and one which will impact all markets, developed and emerging, comes from political contagion from with the EU. If the market genuinely believes that a ‘Brexit’ could increase the prospect of a new wave of EU referendums in other EU countries, then this is where volatility really comes alive.
Key times to consider
The results of the referendum will be announced through the 382 voting centres around the UK, and the Electoral Commission has estimated that we should get around three-quarters of the centres announce votes by 4am London time (1pm AEST). At this point, we should have a fairly clear idea of where the land lies, and by 6am London time (3pm AEST) one suspects the market will have this wrapped up. Voting ends at 10pm on 23 June, and there won’t be an official national exit poll. However, it has been speculated that a number of financial institutions will run their own private exit polls (source: FT – Hedge funds and banks commission Brexit exit polls), and this may be reflected in sterling moves.
If the UK public votes to remain in the EU, we may see a modest relief rally given the recent hedging activity. Still, the market just isn’t prepared for a vote to leave the EU and the broader implications this could have, and a ‘leave’ scenario could really impact the actions of many other central banks in the months ahead.