CBA: The market is getting it wrong on the Brexit risk to the Australian dollar

Photo: Chris Ratcliffe/Getty Images

While the focus of Britain’s EU referendum is naturally centered around the British pound, the UK benchmark stock index – the FTSE 100, UK gilts, and by extension the currency, bonds, and stock markets of Europe other assets like gold, the Japanese yen and the Australian dollar are also affected.

But Richard Grace, the Commonwealth Banks’s chief currency strategist and head of international economics, said in a note yesterday that he doesn’t “believe markets are appropriately pricing the downside risk to AUD/USD, given we anticipate global equity and commodity markets declines will lead to a reassessment of the global economic growth outlook, and the fact the referendum results will be released in the less-liquid Asian time zone”.

Grace says he expects the impact of a vote by Britain to leave the EU would see the pound fall 10% against the US dollar and that the Aussie dollar would also come under pressure. Grace believes the AUD/USD will fall 2.5% against current option market pricing of just a 1% downswing.

But he says that “we see a risk the initial decline in AUD/USD may be larger than 2.5%”.

Grace said the CBA expects the referendum to come down on the side of Britain remaining in the EU. But even against that backdrop he said “the lack of pricing for larger than normal downside potential in AUD/USD is curious because AUD/USD has a long history of big reactions to negative global events”.

The key concern Grace and his colleagues at the CBA have is that “the UK’s EU referendum is a binary event, but the reaction will be asymmetric”.

That is because of the time when the result will be announced – Asian time zone – and reduced market liquidity at that time the risk is “the negative impact on GBP and broader asset markets from a successful vote to leave the EU should far exceed the relief rally on the back of a ‘Bremain’ vote”.

Under that scenario he said “The safe haven currencies of JPY, CHF and USD would strengthen as a bout of risk aversion run through financial markets. Global equity and commodity markets would decline sharply as participants extrapolate the extent of the possible spill-overs for the global economy, not just on the U.K economy”.

“In this environment, emerging market and commodity currencies linked closely to the global growth outlook, like the AUD and NZD, would decline against the JPY, CHF and USD. As described above, global events can have a pronounced short/sharp impact on the AUD” Grace added.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.