As the date of the Brexit referendum approaches, traders seem to be falling into two camps, those who have decided to sit it out and those who are attracted by the prospect of high levels of volatility and the opportunity to make money. Investors on the other hand are concerned about how they will be able to preserve the value of sterling denominated assets like UK property or London-listed shares.
Many CFD and forex brokers are worried that their clients will be encouraged to take a position on Brexit one way or the other, and could see their accounts potentially wiped out by unprecedented swings in the markets, particularly Cable (GBP/USD).
“There seem to be a lot of people and adverts saying this is a great trading opportunity but the wild swings could be too much for all but the deepest of pockets,” said Adam Jepsen, CEO at Financial Spreads. “The markets could easily spike against your trade and close your position before you can make a profit. That would be plain ugly.”
Markets are likely to see a severe move one way or the other, either a relief rally or massive turbulence, particularly as the result will be announced while UK and European markets are open.
“Even if you correctly predict what the markets will eventually do, that doesn’t stop the markets spiking and/or gapping, so that your trades are closed before you can make a profit,” Jepsen added.
Last week more traders began to focus on the implications for the Euro, rather than sterling, as the impact of Brexit could pose some serious questions for the entire European Union project, including the Eurozone currency. Implied volatility on Euro options has been climbing throughout last week. The EUR has been falling predictably against the CHF, but also against USD and JPY.
“I always thought the focus would be primarily on the UK, but if it’s an ‘out’ vote the implications for the Euro are quite dire and more long term,” said Alan Wilde, head of fixed income at Baring Asset Management.
Long term issues for the Euro include the ECB’s failure to maintain the credibility of the currency zone (e.g. the European Commission is considering sanctions on Spain and Portugal for missing budget targets) and the prospect of the UK’s economy actually improving after it leaves, which could sound the death knell for the currency itself. It is no wonder we saw yields on German bunds going down last week as big investors position themselves behind the protective German balance sheet. Some strategists at the big banks still believe the overall Eurozone current account balance looks good, and that traders may well over-sell the Euro. But as ever with situations of this ilk, it is the perception of the quality of the asset class, rather than the reality, which will be moving markets. There is still plenty of negative noise about the EUR.
If the UK leaves then, we could see some long term depreciation in the EUR as EU exporters begin to suffer. It may also touch off currency wars again, as central banks are encouraged to devalue (something that is being frowned on following an agreement between central banks in Shanghai in February).
Trading of GBP currency pairs seems to be driven heavily by opinion polls and will continue to do so until we have the final results of the referendum. Today’s major rally in sterling was, for example, powered by new polls that saw an increase in strength on the part of the Remain campaign. It would also represent sterling’s first back-to-back gain since 3 June.
Similarly, the FTSE 100 is responding to poll news – we saw heavy buying of UK shares in this morning’s London session as traders reacted more positively to the latest intelligence. Indeed, index products may be a safer place to be for traders trying to ride this market than forex.
A Delicate Balancing Act
Traders are caught in a delicate balancing act: there are those who will sit this one out, heeding Jepsen’s advice, but they will have to listen to those stories from the small number who actually made career high profits in a single week by staying in the market. Investors are similarly torn, between safe haven assets like the CHF or German bunds, and the money to be made by staying in sterling and UK equities if the Remain campaign wins this week’s vote. For example, the yield in German bunds rose 3bps on news that the Remain vote might actually close the gap (today’s FT poll has opinion neck and neck). This shows investors are moving money out of bunds and back into sterling assets in anticipation of a risk off rally.
HSBC announced today that Brexit, if it occurs, could cost sterling up to 15% of its value against other currencies. This would be an enormous forex trade to be on the right side of, but again, traders would need to endure the volatility swings we will see in the leap up.
Betting markets were reported to have seen a 7 point swing in favour of Remain, with an implied probability of 72% that the UK will vote to stay in the EU.
The volumes of forex traders we see this week will also be a big test for the brokers, including the banks that clear trades through the interbank market. Since 2010 banks have been cutting back on the number of experienced traders they employ in the FX market, relying more heavily on technology. London research consultancy Coalition said that the number of human traders at major banks has fallen 22% since 2010, while the proportion of foreign exchange traded electronically has jumped from 57% to 76%.
There are also fears that many algorithmic risk management and trading programs simply have not been tested by an event of this magnitude in the markets – quite a few could shut down if volatility becomes too high, allowing human traders to be the ones to stay out there in the surf, so to speak.