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Being as Clear as Possible: Thursday's Brexit Vote a Direct Threat to the Euro

Being as Clear as Possible: Thursday's Brexit Vote a Direct Threat to the Euro

Christopher Vecchio, CFA, Senior Strategist
Being as Clear as Possible: Thursday's Brexit Vote a Direct Threat to the Euro

Fundamental Forecast for EUR/USD: Neutral

- The BOE sounded the alarm over a Brexit

- …as the Fed, BOJ, and SNB all altered their policy plans as a result of the risk it poses to Europe and the global economy.

- FX market volatility is rising ahead of the UK-EU referendum – it’s a good time to review risk management principles.

To receive reports from this analyst, sign up for Christopher’s distribution list.

It was another volatile week for the Euro as market participants have proven increasingly nervous on approach to the June 23 UK-EU referendum. Risk assets – higher yielding currencies and global equities – have been nothing less than highly sensitive to Brexit-related headlines and central bank activity, or rather, inactivity, as on approach to this Thursday. The extent of worry was crystalized with what the Federal Reserve, Swiss National Bank, and Bank of Japan implicitly said through their inaction: we don’t want to waste ammo now in case we need to use it later.

What’s the ‘later’ that the central banks are waiting for? Not just the vote on the surface. While the Euro isn’t in the spotlight, the Euro is indeed having a “political moment” right now. The very heart and soul of the Euro is at stake. The whole premise of the European Union project, going back to its humble beginnings rising from the ashes of World War II as the European Coal and Steel Community, was to promote an economic vision of a unified Europe where, regardless of the language you spoke, the country you lived in, or culture you partook in, you were a European, through-and-through.

Let’s put a potential Brexit in context for the Euro. First, the remnants of the GFC remain, with peripheral countries stagnant, and in turn, a lack of federal union has siphoned sovereignty from peripheral European countries. More recently, the Syrian Civil War has produced an uncontrollable wave of refugees that has revealed considerable infrastructure issues and security concerns to the point that countries are building fences and have threatened to renege on their Schengen Area duties to close their borders. The principle of free movement in Europe is at stake.

If the British are allowed to leave the European Union, recent polls from various countries – peripheral and core alike – have showed that populist backlash against the pan-European project is growing. Polls have emerged from Germany, Holland, and Italy in recent weeks that suggest at or near 50% of citizens would support a UK-like referendum regarding their own respective memberships. This truly is a slippery slope, as we said in early-May, it would open up the Pandora’s Box of speculation: markets would begin trying to price what varying forms of an EU breakup would look like.

The Brexit component for the Euro is clear: it raises the question of how permanent being a member of the European Union actually is. The narrowing of the recent UK-EU referendum polls in the run up to the June 23 vote is increasing the probability of these questions from being answered – which would be to the Euro’s detriment. If markets are overreacting regarding the British Pound (exhibited by wide price swings and elevated levels of implied volatility), it’s clear that a potential Brexit has been underestimated this event in terms of the existential implications it has for the Euro by a potentially wide margin. The British Pound will definitely suffer in the event of a Brexit – but so too will the Euro.

To receive reports from this analyst, sign up for Christopher’s distribution list.

This is an updated version of our Q2'16 Euro Forecast, "EUR/USD Stuck in No-Man’s Land Headed into Q2’16; Don’t Discount ’Brexit’"

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