Is a Brexit on the cards?

21 June 2016  •  Source: Natixis’ senior forex analyst, Nordine Naam

Last week marked a turning point in the UK’s Brexit campaign, with heightened concerns of a vote to leave weighing heavily on riskier assets. Ever since opinion polls have swung in favour of a UK Brexit, currencies such as the US dollar, the yen and the Swiss franc have played their part as a safe haven currency for investors, on the back of the pound’s rise in implied volatility.

Indeed, The EuroStoxx 50 has retreated almost 9% since the start of June, while Brent prices have returned to US$47 per barrel. What’s more, this has caused the sovereign debts in both the eurozone and the US to rise sharply, with the German 10-year rate, for example, moving into negative territory for the first time ever.

USD: currency bolstered by the renewed risk aversion

Despite the Federal Reserve (Fed) opting to maintain the status quo last week, the US dollar’s value appreciated, while the DXY dollar index made brief inlays above 95. This positive news came despite the Federal Open Markets Committee’s (FOMC) statement holding mixed sentiments over the US economy’s health and the ‘Dot Plot’ – a forecast from Fed members that predicts the central bank’s key interest rates’ movements – now showing downward revisions for 2017 and 2018.

Certainly, the dovish tone was echoed by the Fed’s Chair, Janet Yellen, who suggested that the central bank would wait and see whether or not the US’ poor job creation figures (revealed in the Employment Situation Report a fortnight ago) were, in fact, a sign of wider economic weakness before taking action. That said, the Fed still predicts that two Fed Fund rate hikes this year, with the belief that promising mid-term growth is on the cards. With this in mind, while we no longer expect the Fed to move in July, we believe September is the most likely timing, although the market is not pricing in any tightening before 2018.

This week, we expect the US dollar will continue to benefit from the Brexit jitters up until Thursday. Thereafter, should the UK vote to remain, any greenback advances will be likely erased. But, come the beginning of July, there may be another recovery should expectations of a monetary tightening in September begin to surface.

On the other hand, if the UK votes to leave the European Union (EU), the dollar will retain its safe haven status and continue to appreciate further. Should this latter scenario occur, the DXY index may appreciate towards 101.

EUR: EUR/USD heading towards 1.10

The EUR/USD extended its correction towards 1.114 – mainly due to concerns over the negative effects that a potential Brexit poses to the eurozone. Of course, should this occur, we would expect the eurozone long rates to decline sharply to the point where they become even less attractive relative to US long rates.

Indeed, these concerns are intensified by the one-month Risk Reversals 25D remaining negative, indicating that the EUR/USD would weaken in the event of a Brexit. Should this scenario unfold, we see the EUR/USD correcting further towards 1.02 in the coming weeks as the greenback will become the investor’s safe haven currency. In these last days before the referendum, we anticipate the EUR/USD continuing to correct towards 1.10. One final indicator to follow is Tuesday’s ruling by Germany’s constitutional court concerning Outright Monetary Transactions (OMT).

If that scenario unfolds, we see the EUR/USD extending its correction towards 1.02 in coming weeks, bearing in mind the greenback will play its role as a safe haven currency. In the days leading up to the referendum, we see the EUR/USD correcting towards 1.10. Before the EU referendum, watch out for Tuesday’s ruling by Germany’s constitutional court regarding Outright Monetary Transactions (OMT) – the ECB’s programme to buy peripheral eurozone states’ sovereign bonds.

GBP: heading lower under the strain of a possible Brexit

The pound has continued to slide after a series of opinion polls indicating a marginal four percentage point lead for the Leave campaign, with the EUR/GBP testing 0.80 and the GBP/USD at 1.40. Certainly, this caused the one-month implied volatility rate for the EUR/GBP to rise sharply towards 25% and the GBP/USD to 27% – despite actual volatility standing at 11%. This indicates that the market is scrambling for currency protection – whatever the cost – in order to hedge the risk of any potentially steep losses.

If the Leave campaign are victorious, our view is a sterling correction remains likely in the coming weeks in light of the enormous economic uncertainties that lay ahead both economically; the risk of a recession, eroding growth potential, and uncertain trade arrangements between the UK and European Economic Area, as well as politically; the possible resignation of UK Prime Minister, David Cameron, and the risk of a second Scottish independence referendum. Indeed, the GBP/USD could correct as low as 1.20, while the EUR/GBP could experience an ascent towards 0.85.

A vote to remain, however, will likely cause the GBP/USD to pull back towards 0.74 in the short-term, with a further decline to 0.71 expected by the end of 2016.

JPY and CHF: under pressure

As safe haven currencies, both the Swiss franc and the Japanese yen appreciated last week, in reaction to Brexit opinion polls. In Japan, the market was disappointed by the Bank of Japan’s (BoJ) decision to maintain the monetary status quo during last week’s meeting, even though this had been expected. Certainly, ahead of the UK’s referendum, the BoJ was not willing to fire its ammunitions for fear that – in the event of a Brexit – the yen could sky-rocket. On the other hand, a vote to remain will cause the USD/JPY to rebound slightly, with the greenback once again drawing strength from the possibility of both a Fed Funds rate hike in September, and the BoJ announcing further monetary easing in July.

Meanwhile, last week’s Swiss National Bank (SNB) meeting sent a strong signal to the market that the central bank is prepared to act should a UK Brexit occur. With the EUR/CHF currently testing 1.08, the pair is likely to test 1.07 following a leave vote, forcing the SNB to aggressively intervene in the foreign exchange market to prevent a sharp appreciation of the Swiss currency.

A vote to leave, however, may allow the EUR/CHF to recover above 1.09.

New Zealand and Australian dollars prove resilient…

Despite a downturn in light of rising oil prices and risk aversion in the run up to the UK’s vote, the kiwi dollar still managed to hold steady against the US dollar at around 0.705. Certainly, the better-than-expected macroeconomic indicators contributed to this, with GDP Q1 growth of 0.7% (beating the 0.5% consensus).

Similarly, the New Zealand manufacturing PMI was once again on the rise in May, from 56.6 to 57.1 – confirming the economy is, in fact, in a period of growth. But, a UK vote to leave may change this course – creating new risks in the New Zealand economy. As one would expect, if the UK remains an EU member, the NZD/USD could experience a rebound towards 0.722.

Meanwhile, the AUD/USD also managed to stabilise, despite very mixed employment data showing that most job creations were, in fact, part-time positions. What’s more, Chinese growth remains delicately balanced – underlined by weak private sector investment as well as the slowing M2 money supply.

Given iron ore prices are, once again, in retreat – down to US$50.7 per ton – the AUD/USD will remain on the back foot. Indeed, the pair could weaken further following a UK vote to leave, while the UK remaining would result in the AUD/USD rebounding temporarily towards 0.74.

The Canadian dollar and Norwegian krone have weakened

The Canadian dollar and Norwegian krone recorded the sharpest declines this week, as Brent pulled back towards US$47 per barrel but, above all, due to the US dollar’s better performance, which has been spurred by the Brexit jitters.

Given high volatility for both currencies is expected to continue, the Canadian dollar and Norwegian krone will continue to take the strain of the UK’s vote this Thursday. A vote to remain will see the USD/CAD heading towards 1.27 and the USD/NOK towards 8.20.

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