Market analysis: Brexit threatens domino effect

Should the UK decide to leave the European Union, it would set a precedent which others might also be tempted to follow. Jason Alden / Bloomberg

Last week was the week in which sterling finally started to wake up to the possibility of Britain leaving the European Union, or Brexit.

The British pound dropped about 3.5 per cent against the dollar and lost ground against a basket of currencies after it became clear that the prime minister David Cameron would have a real battle on his hands to convince the British public to support his case for staying in the EU, with a referendum now called for June 23.

Sterling has admit­tedly been weak since the start of 2016, with its softness frequently explained by the possibility of Brexit.

However, the main reason for the pound’s weakness up to about a week ago was really related to relative interest rates between the US and the UK, as it has been for much of the past few years.

The pound-dollar exchange rate (popularly known as Cable) has moved in line with this interest rate differentials for a number of years, with this differential moving sharply in the dollar’s fav­our after the US Federal Reserve raised interest rates in December, and the Bank of England indicated in January that a rise in UK rates was not on the horizon for a considerable time.

However, the gap that has opened up between Cable and rate differentials since early last week can now clearly be explained by Brexit, after the mayor of London and six other prominent members of the UK government came out against the prime minister’s deal, thus casting doubt on Mr Cameron’s ability to win his referendum. And now with the actual Brexit referendum itself not due until June, there is every chance that it can probably fall further still.

The experience of last week has shown that there is scope for tremendous volatility in the coming months as the financial markets react to every opinion poll that is released on the issue. This is likely to intensify the closer we get to the referendum itself, with the example of the Scottish referendum on independence providing a useful reference.

The possibility that Great Britain could leave the biggest single market in the world will raise considerable questions about UK growth, about interest rates, capital flows and foreign direct investment, as well as about sec­urity and numerous other political issues and risks. Certainly the campaign to stay inside the EU will flag all of these, thus creating an atmosphere of fear and uncertainty about the likely effect of Brexit should it happen, which will in turn transmit itself into the markets.

Historically, Cable has traded over the past 30 years within a broad 1.35-2.10 range.

However, back in early 1985 it fell briefly to 1.05, on the back of exceptional circumstances related to weak oil prices, given sterling’s status at the time as a petro-currency. Not surprisingly, therefore, the markets are dusting off their projections about what could happen in the event of equally such exceptional circumstances, with the assumption growing that the pound could immediately be subjected to a jolt lower, to at least around the US$1.20 level. This would probably be a relatively short-lived sell-off, although how quickly and how much it would be able to recover would still depend on many factors.

However, it is not only sterling that stands to be negatively affected by Brexit. No country has ever left the28-member EU, so should the UK decide to leave it would set a precedent which others might also be tempted to follow, opening up a potential Pandora’s Box of potential consequences.

After all, the current condition of the EU is not strong with economic growth weak and the poli­tical splits over issues like immigration and the Greek crisis still very raw. For the 19-member euro ­zone in particular there would be clear downside risks, with the likelihood that some of its members might flirt with the possibility of pulling out.

But even if the rest of the EU and the euro zone did manage to stick together, there would also likely be negative consequences for European growth, trade, investment and fiscal policy from the UK’s departure. At a time when the US Fed is likely to be considering a second rate hike of its tightening cycle, Brexit could be the issue that consigns both sterling and the euro to much lower levels.

Tim Fox is the chief economist and head of research at Emirates NBD.

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