Global Daily – Brexit risk premium still to build

by: Nick Kounis

Global-Daily-Insight-12-January.pdf (119 KB)
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  • Brexit risks are set to come more in focus in markets
  • Prime Minister Cameron has hinted at referendum in H2
  • A vote for Brexit seems a higher risk than commonly judged
  • Sterling has weakened significantly against the dollar…
  • … but this reflects rate spreads, with the Brexit premium still to come

 

 

Brexit can have a profound impact

The UK’s future in the EU has the potential to be one of the biggest issues for the global economy and financial markets in 2016. The results of a possible Brexit referendum can have a major impact of the world’s largest trading bloc. In addition, it could have even bigger impact on the UK itself. The long-term impact depends on the UK’s trading relationship with the EU following any Brexit, and that in itself would depend on what would be agreed in the negotiations that follow. However, there could also be political knock-on effects for the UK itself, as it could make a new Scottish independence referendum more likely.

 

12 Jan

 

Near term impact whatever the outcome

In the near term, the UK economic outlook is less rosy than it would otherwise be whatever the outcome of the referendum. This is because businesses, both domestic and foreign, will likely hold off investment until there is more clarity. This is a factor that could further delay BoE rate hikes, so it is negative for sterling. Furthermore, the more general Brexit uncertainty is also negative for sterling as a risk premium is likely to build.

 

Sterling has fallen, but mostly on rate differentials

Sterling has fallen sharply against the dollar over recent weeks. However, that does not mean that markets have fully discounted Brexit risks. Indeed, we would argue the opposite. The movements in Sterling seem to be largely tracking short-term interest rate spreads between the US and the UK (see chart). In particular, BoE rate hikes have been scaled back by financial markets given the subdued inflation outlook and moderate UK growth. In contrast, the Fed has embarked on an – albeit likely very slow – rate hike cycle. This means that much of the Brexit risk premium is still to come.

 

Brexit issue becoming more of a reality

Up until recently, the Brexit issue seemed to be treated more as a theoretical political issue going on in the background. After all the UK government has committed to a referendum by 2017, so it could be a long way off. However, it is becoming increasingly likely that a referendum will be held already in the second half of the year. Over the weekend, Prime Minister Cameron hinted strongly at this prospect. He said that he was confident in reaching a deal on the UK’s ‘new’ terms of membership next month. That would open the way for a referendum later in the year.

 

Further sterling weakness ahead

We continue to expect further weakness ahead for sterling against the dollar as the Brexit risk premium builds and as rate differentials continue to move in the favour of the dollar. Uncertainty is likely to remain high in the run-up to the referendum, as polls currently suggest that the outcome is a close call. A vote for the UK to stay in the EU would likely trigger a rebound, while a vote for Brexit would likely usher in more uncertainty until the direction of the negotiations became clear.