Will Britain leave the EU? The currency thinks so…

The UK is talking about leaving the European Union. We were curious to see what impact such talk is having on the Pound and what it might mean for businesses trading with either the UK or Europe, should the unthinkable happen and the Brits vote to leave.

 

A referendum is scheduled for the 23rd of June where the British public will be asked to go to the polls and answer “Should the United Kingdom remain a member of the European Union or leave the European Union?” The latest poll results show 51% will vote “stay” versus 49% “leave” with 3 months to go, so it could go either way.

 

So whats going on?

 

Britain originally held a referendum back in 1975 shortly after it had joined what was then the “Common Market”. The country voted to stay back then, but there have been growing calls for another vote because the EU has changed so much over the last 40 years.

 

The EU is now made up of 28 countries and the organization has been extending its control over more and more aspects of daily life, resulting in the European project becoming far more than just a free trade area.

 

There is now legislation dictating policy from environmental issues and human rights to the less serious but equally intrusive European food police regulating the amount of cinnamon that can be put into pastries or how olive oil is served to restaurant goers.

 

This “overreach”, combined with a rising cost of living and stagnant incomes has lead traders in the currency markets to place a higher probability on a Brexit scenario than was expected just a few months ago, which has lead to a significant weakening of the British Pound this year.

 

The following chart comes courtesy of HSBC and shows how the GBP-USD exchange rate has traditionally tracked interest rate expectations between the US and the UK. As expectations for either a divergence or convergence of interest rates between the two countries change, this used to drive the currency market.

 

However, you can see this correlation has broken down since the election in May last year, when the conservative Government won and the prospect of a referendum became a serious one. The referendum is the only event on the horizon which is big enough to have caused this breakdown.

 

To date, the Pound has fallen by about 9% against the US dollar, if the UK vote to stay it is likely this 9% will very quickly be traded back and the GBP will strengthen against the Dollar. Should the UK vote to leave however, there is a high probability this weakness will continue.

 

The UK has been keeping very bad company economically speaking, with large fiscal and current account deficits. The UK has been viewed by markets as part of the larger European club and these deficits have been overlooked as they focus on interest differentials, but the spotlight will very quickly turn to these imbalances should the UK vote to go it alone. In this scenario, HSBC thinks there is a high likelihood the GBP could fall at least another 9%.