Nothing is more important for politics, markets, and economics in the UK, Europe and around the world this week than the British referendum on its EU membership.
The Leave campaign appears to have taken the ascendancy with momentum shifting away from UK prime minister David Cameron’s Remain camp. Poll after poll has shown that Remain’s winning margin has crumbled, not just this week but over the entire month.
That trend in the polls has been accompanied by an increase in tension across global markets with the pound, stocks, credit markets, and commodities coming under pressure. On the other side of the coin, safe havens like gold, the Japanese yen and high-grade sovereign bonds have all been bid.
But even though the Leave vote has the momentum, the poll still appears too close to call. That means the economic and market impacts remain uncertain as well.
Add in the low liquidity that is creeping into markets as risk managers restrict traders at banks and fund managers from betting too much in the lead up to the vote and we have a combination of risk and illiquidity which almost guarantees a huge reaction when the decision to stay or go is announced.
Recognising this, the folks at Capital Economics in the UK have taken an in-depth look at the potential consequences of a range of different outcomes in the aftermath of the vote.
They’ve broken the outcomes into four types of results based on the level of support for the Remain or Leave camp.
- Firm remain >55% vote to stay in the EU: The economy will bounce back, the BoE will raise rates later this year, sterling will surge to 1.50 and bond yields rise, stocks rally also.
- Weak remain <55% vote to stay in the EU: The economy bounces back but is constrained by lingering political uncertainty and the chance of another referendum in coming years, interest rates don’t rise until early 2017, sterling rallies back to 1.45, equities recover.
- Weak leave <55% vote to leave the EU: Economic growth drops 1-2% than otherwise over the next 2 years, sterling collapses to 1.20, bonds rally, and stocks come under pressure.
- Firm leave >55% vote to leave the EU: The economy slows markedly but there is no recession, sterling could fall below 1.20, markets price for BoE easing, stocks come under intense pressure and capital flight is a risk
While Capital Economics is looking at the outcomes from a UK-centric point of view, the impact on the pound, British economy, bond, and interest rate markets is likely to be mirrored to some degree across global markets.
Late last week, both the Swiss National Bank and “sources” at the Bank of Japan suggested a coordinated approach from the big global central banks is on the cards should Britain vote to leave.
Likewise, the high degree of correlation between global bond markets and the sterling (GBPUSD) rate suggests we can continue to overlay bond rates with the pound’s reaction to the vote.
Stocks have resisted the bond and currency markets fears reasonably well so far. Perhaps that’s because of the different mindset of bond and stock traders. Bond traders are naturally more pessimistic than stock traders. The former are naturally worried about the return of their money while the latter concern themselves with the more optimistic return on their money.
That means if Britain votes to leave, the biggest reaction outside sterling could actually be in global stock markets as traders grapple with what it means for growth in the UK, Europe and the globe more broadly.
Of course, should Britain vote to stay, then markets around the world will quickly run higher with sterling and unwind this huge bout of risk aversion that has gripped them in the past two weeks of trade.
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