One way or another, financial market volatility appears almost certain to spike later in the week as traders and investors around the world react to the UK referendum on whether to remain a member of the European Union (EU).
While much of the volatility will be centered on UK financial assets, movements in the Australian dollar are also likely to be wild, given its reputation as being a gauge on investor sentiment globally.
Although markets have recently adopted the view that a “Brexit” is unlikely to eventuate, helping to boost risk assets including the Aussie, no one can say with any certainty that this outcome will occur.
Even with the tragic death of MP Jo Cox which saw momentum swing back towards the “Bremain” camp, the polls continue to point to an incredibly close result, likely ensuring markets remain on edge right up until voting closes at 7am on Friday morning in Sydney.
To the NAB’s FX strategy team, led by Ray Attrill, markets shouldn’t underestimate the scale of a potential spike in risk aversion in the case that a Brexit occurs, suggesting that the Australian dollar could tumble below the US70 cent level in the immediate aftermath of such an outcome occurring.
“The transmission mechanism from a vote for ‘Brexit’ to the AUD would come via an expected sharp rise in levels of market risk aversion,” says the bank. “Our sense is that AUD would quickly revisit the current cycle lows in the 0.68-0.69 area.”
However, while that is the bank’s base-case scenario should a Brexit vote prevail, it notes that the declines could be significantly larger should volatility spike to levels seen during other periods of acute financial stress in recent years.
“In attempting to quantify the potential implications for the AUD, we note that last August when Chinese stock and currency market-related stresses saw the ‘VIX’ proxy for market risk aversion briefly above 50 from below 20, the AUD fell from above 0.74 to below 0.69,” says the bank.
“Stressing our short term fair value model with similar levels for the VIX, and keeping all else constant, we derive a fair value estimate of 0.64.”
Yes, based on modeling from the NAB, a rise in financial market volatility to levels seen when the People’s Bank of China devalued the Chinese yuan in August last year would have the potential to see the AUD/USD slump more than 10 cents from its present trading level of .7450.
The chart below, supplied by the NAB, looks at what such a move would look like based on the bank’s modeling.
While the bank stresses that this is not an official forecast, it “illustrates the potential for severe downward pressure in the event that global risk markets are freaked out by a vote for Brexit”.
On the contrary, should the UK vote to remain as a member of the EU, the bank suggests that the upside for the Aussie will likely be limited in scale.
“0.75-0.76 is likely in case of vote for ‘Remain’,” it says.
The sentiment expressed by the NAB mirrors that of Richard Grace, chief currency strategist at the Commonwealth Bank, who suggested last week that markets were not adequately pricing downside risks in the Aussie ahead of the EU referendum.
“Markets (aren’t) 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,” said Grace.
Although he forecasts that the AUD/USD would likely fall around 2.5% should a Brexit vote prevail, he admits that “the initial decline in AUD/USD may be larger than 2.5%”.
“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.”