With the UK referendum on its membership of the European Union (EU) now just 10 days away, there is still a huge amount of uncertainty about the outcome. This is playing havoc with the currency markets and no doubt causing plenty of lost sleep for corporate treasurers and finance teams charged with managing their firm’s currency risks. Sterling volatility is incredibly high and has been since prime minister David Cameron announced the poll in February.
The markets, which are usually data driven, are now dominated by the opinion polls. Over recent few weeks sterling has seen something of a rally as polls showed a widening lead of 5 to 10 points for the ‘Remain’ campaign. However, in the past few days, the polls have pointed to a resurgence of support for a ‘Brexit’, which has stopped that sterling rally in its tracks. Sterling has not been moving directionally but been rangebound within a hugely volatile range. Until the vote takes place and the uncertainty over Britain’s EU membership is known, this pattern of volatility will remain – and if anything is likely to increase, as market nerves fray in the approach to voting day.
Against this backdrop, the advice for the vast majority of firms with currency risk management policies in place, is to back that policy and continue to plan for the knowns, as defined within those plans – rather than to start second guessing and taking potentially expensive punts on the outcome. The result, not just of the referendum, but for the whole UK economy, is incredibly uncertain, so moving away from a pre-agreed policy is filled with risk. For treasury departments that have a comprehensive plan in place, the best course of action is almost certainly to stick to it. Firms should not be carrying open exposures across referendum day that they would not normally have open.
For firms that have a solid currency risk mitigation strategy in place, focusing on the short-term volatility in the markets is unnecessary and can act as a distraction from following the policy and the commitments within it. The outcome of the EU referendum is uncertain; for corporate treasurers and chief financial officers (CFOs), the challenge is to focus on the certainties of their risk mitigation policies.
The next move
What happens after the referendum very much depends on the outcome, but uncertainty won’t evaporate overnight. If the UK votes to leave the EU, there will be a prolonged period of uncertainty – and therefore volatility – as the details of what a post-Brexit UK will look like are thrashed out.
Trade agreements are one of the central issues, as the UK would need to renegotiate its arrangement with Europe, its largest trading partner. It is almost certain that the UK will no longer have the same access to the single market in the event of a Brexit and therefore new trade tariffs would need to be agreed. This process could take up to two years and could have huge implications for any firm engaged in trade with the EU. For firms that don’t trade with the eurozone it will be business as usual in most cases. For example, the EU has no existing agreement with America, so firms trading with the US are unlikely to see any immediate change in their trading relationships.
From a currency perspective (see fig A below), a Brexit is likely to weigh heavily on both sterling and the euro. It would be no surprise to see the value of sterling fall by as much as 15-20% against the dollar, perhaps going as low as $1.20. The fall against the euro would be less dramatic, as the single European currency is also likely to be driven lower due to a Brexit raising serious concerns over the future of an economically and politically integrated Europe. Euro-dollar parity at some point in the second half of the year would be a distinct possibility.
With such a large potential downside for sterling against the dollar – in particular in the event of a Brexit – there is a possibility that firms could see their future dollar purchase commitments impacted. A firm may have hedged for all the right reasons, but such a fall in sterling would leave firms with standing commitments in place to sell dollars at much higher rates exposed in the short-term – with the risk of being margin called by their brokers. One measure that firms can take to help mitigate against their risk in this eventuality is to review their existing currency commitments and talk to their banks and brokers, to ensure covenants wouldn’t be broken and to ensure that they have adequate cash cover in place for all possible outcomes.
On the face of it, a ‘Remain’ vote offers more certainty and this is likely to be reflected in a stronger pound. Nonetheless, there are some broader question marks over the UK’s economic recovery that have effectively been put on hold pending the referendum and will need to be answered.
It’s possible that the UK could have a spectacular second half in 2016, as uncertainty evaporates and confidence returns. However, there have also been some warning signs that the country’s economic recovery of recent years could now be stalling. It remains to see whether this is a result of the referendum and therefore a blip, or a longer term, more fundamental issue. If it’s the latter then we may well see interest rates cut further, before they are raised. The fact is, it is impossible to tell until the referendum is out of the way. Even in this scenario, there is likely to be a degree of uncertainty after June 23.
If the UK votes to remain in Europe, sterling would likely strengthen against the dollar, albeit not with as much upside, perhaps increasing by 5-10% to around $1.59. The reason for this is that the US is further along in the recovery cycle than the UK and has moved into an interest rate rising cycle. By contrast, the recovery and monetary policy in the UK looks less certain.
Sterling is likely to post greater gains against the euro as, while the eurozone will have successfully emerged from one potential crisis, there are plenty of other issues. They include growing nationalism in many European countries, immigration and border controls, as well as lingering question marks over sovereign debt in Greece that have not been fully put to bed. As a result, the pound could strengthen to somewhere around €1.40.
The EU referendum has created a huge amount of uncertainty and consequently volatility in the currency markets. This uncertainty won’t come to an abrupt end on 23rd June and businesses need to be prepared to weather further volatility. While it is impossible to predict what will happen, it is important for treasurers to have comprehensive currency risk management plans in place, to stick to them and to work with their banks, brokers and advisors to ensure their commitments will be upheld in the event of all possible outcomes.
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