Find out what Brexit could mean for the markets and how a hard or a soft exit from the EU could affect traders.
While GBP/USD is likely to fall if the Brexit agreement is rejected. However, using the EU referendum as a blueprint, this article highlights how markets could play out once the result of the cabinet or parliament vote is announced.
Brexit uncertainties have been a core driver of sterling volatility of late, with the indecisive direction seen over recent weeks highlighting the uncertainty over the direction of the EU referedum. We have reached a fork in the road, where approval of the deal leads to a sterling rally amid expectations of a simple pathway to a deal. However, rejection at either Cabinet, parliament or EU level could spark a substantial reversal for the pound given the huge uncertainty that it brings. A vote of no confidence, a second referendum, a general election and eventually a no-deal Brexit. All of these are possibilities if this deal is rejected.
However, the key question for traders is quite how to plan for this impending volatility. Fortunately, we have a blueprint for a potential major announcement in the markets, with the EU referendum result providing a significant trading opportunity in hindsight.
The chart below highlights the period before, during and after the EU referendum in 2016. The interesting part is the way that markets often digest information in different stages.
The automatic reaction from markets is to apply perceived economic repercussions equally to both the pound and stocks. Thus, given that Brexit was perceived as negative for the UK economy in the near term, we saw stocks and the pound fall in tandem. However, the FTSE 100 has a particularly significant inverse correlation between the pound and stocks. Thus, after that initial response, we soon see the inverse relationship kick in. With that in mind, it would have been profitable to buy the FTSE 100 after that initial sell-off, benefitting from the reversion onto its rightful path alongside the subsequent gains in the aftermath of the announcement.
This could have been hedged by going long GBP/USD at the same time, to protect against the possibility of markets shifting their perception of what Brexit means for the economy. Should we suddenly see markets perceive the decision to leave the EU as positive for the UK economy, we would see GBP/USD rally and the FTSE 100 fall. However, if you are right, the already oversized move from the pound means that the GBP/USD downside is likely to be dwarfed by the FTSE 100 gains which have to not only reverse their original losses, but also push upwards from there.
This is a strategy that can be employed when we hear major announcements from the likes of the Cabinet and parliament as they vote on the proposed plan. There is a strong chance that we will see the plan rejected, raising the possibility of huge economic and political upheaval. Whether it will play out the same remains be seen. However, the natural instinct is to think that something negative for the UK should be reflected by a weaker FTSE 100. That is typically not the case, and it is worthwhile noting that when we see both GBP/USD and the FTSE 100 move in tandem, it is often fleeting. Given the highly internationalised nature of the FTSE 100, many firms earn abroad yet report in pounds. Thus, if we see GBP deteriorate in response to a poorer economic outlook, you will typically see the FTSE 100 rise as the value of foreign earnings are enhanced.
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