Sterling under pressure ahead of crucial EU referendum

Enrique Díaz-Álvarez01/Mar/2016Currency Updates

Since David Cameron’s Conservative party strolled to a comfortable General Election victory in May last year, currency markets have been eagerly awaiting details of the Prime Minister’s pledge to hold an in/out referendum on Britain’s membership with the European Union, which was promised to happen before the end of 2017.

After the recent agreement between David Cameron and the European Union, the referendum date has been set for 23 June. As for the outcome, the latest opinion polls suggest the result of the referendum is far from guaranteed.

The average of several recent polls indicates that the vote to stay in the EU has a small lead, though this appears to have widened somewhat since the announcement of the agreement with the EU. Bookmakers are placing the odds of a Brexit at around 30%.

Investors have become increasingly concerned about the chances of a Brexit since the turn of the year. This has contributed heavily to the Pound’s sharp decline so far in 2016, which has seen Sterling lose over 5% of its value in trade-weighted terms. It touched its weakest position against the Euro in thirteen months in February (Figure 1) and a seven year low against the US Dollar.

Figure 1: Historical Evolution of GBP/EUR (2015 – 2016)
Figure 1 Historical Evolution of GBP EUR (2015 2016)

Source: Thomson Reuters Datastream Date: 01/03/2016

Implied volatility in the GBP/USD currency pair has also increased since the turn of the year to its highest level since last year’s General Election (Figure 2).

Figure 2: GBP/USD Implied Volatility (2015 – 2016)
Figure 2 GBP USD Implied Volatility (2015 2016)

Source: Thomson Reuters Datastream Date: 01/03/2016

However, it’s significant that the GBP/EUR rate has remained in a tight range over the last few days. Sterling has fallen sharply against the US Dollar but in the context of a generalised Greenback rally, rather than specifically due to Brexit concerns.

But what could the outcome of the EU referendum mean for the UK economy and its currency?

Britain remains a member of the EU

As things stand this remains the more likely scenario. David Cameron’s renegotiated deal would be in place, which includes changes to migration, sovereignty and benefits, among others.

Much of the recent uncertainty that has weighed on the Pound, and will likely continue to weigh on the Pound in the run-in to the referendum, would be alleviated. Sterling would therefore be well supported in the weeks following, much like it was after the Scottish Referendum and last year’s General Election.

Sterling strength would be especially prominent if the Bank of England were to defy current market expectations and begin tightening monetary policy before the year is out.

In the event of an ‘in’ result, we would expect Sterling to quickly retrace all its losses against the Euro since roughly the beginning of 2016, which is when markets began focusing on the Brexit risk. This would mean a rally of 5-6% against the common currency.

Britain leaves the EU

While estimates regarding the impact of an EU exit are broad and wide ranging, the general consensus points to a net negative for the UK economy in the short-term. The substantial costs inflicted on the UK economy would pose a ‘very risky gamble’ according to the Centre for Economic Performance (CEP).

Although strongly contested, UK unemployment would be at risk of increasing as 3 million jobs, around 10% of the overall domestic workforce, is associated with exports to the EU.

Exporters would likely be under heavy pressure considering the EU accounts for 50% of the UK’s overall export revenue.

Britain’s current account deficit is likely to worsen, leaving the Pound particularly vulnerable from a lack of investor sentiment.

Many analysts have suggested that a Brexit could even knock as much as two percent off UK GDP, lead to a snap recession and have long-lasting effect on business investment, the housing market and consumer confidence.

It could also incentivise banking groups to move their headquarters out of the capital, which could jeopardise London’s standing as the financial hub of Europe.

A Goldman Sachs estimate has recently suggested that an abrupt interruption to incoming capital flows following a Brexit could even shave as much as 15-20% off the value of the Pound in trade-weighted terms and send Sterling to its weakest position since 1985. This worst-case scenario, despite being extremely unlikely, would provide a significant challenge for the domestic economy and UK businesses, particularly those looking to import from abroad.

What does the future hold for Sterling?

We do not expect Britain to leave the European Union this year.

As was the case with the Scottish referendum, we think that, as the referendum date draws near, the status quo will attract more support than the polls are currently giving credit.

In our view, the subsequent rally in the Pound following an ‘in’ result would make up for any depreciation suffered from uncertainty leading up to the referendum.

We therefore expect Sterling the end 2016 somewhat higher than current levels against the US Dollar and much higher versus the Euro, amid aggressive monetary easing by the European Central Bank.


Receive daily and/or weekly market updates via email



Written by Enrique Díaz-Álvarez

Chief Risk Officer at Ebury. Committed to mitigating FX risk through tailored strategies, detailed market insight, and FXFC forecasting for Bloomberg.