Coming into the final week ahead of the Brexit vote, GBP has been given a fillip by the weekend polls, which showed a recovery in the “Remain” vote even in polls done before the tragic murder of MP Jo Cox. The latest Survation poll showed Remain 3 points ahead, while the others over the weekend broadly showed the camps neck and neck. GBP has rallied sharply on the news, and will probably gain some more, if, as I expect, Remain continues to gain ground into the vote. In the end, in spite of concerns about lack of sovereignty and a (largely justified) deep mistrust of the EU and its institutions, the fear of the unknown and the warnings of the economic consequences of Brexit are likely to hold sway. It’s not a certainty, but I would be wary of betting against Remain ahead of the vote.
But after the vote is a different story. As I have noted before, while there is a perceived risk premium in GBP, the pound isn’t cheap even with this risk premium. On the contrary, it continues to trade well above PPP against the USD. While PPP is not a great guide to the appropriate level of the exchange rate in many currencies, at least not in the short run, performance relative to PPP is nevertheless a good starting benchmark, especially in developed markets. In the long run, currencies do move with prices – i.e. it is the real level of the currency that matters – and in recent years relatively high inflation in the UK means the appropriate value of GBP is lower than it used to be. The chart shows GBP/USD relative to PPP over the last 20 years, and it is notable that PPP has dropped from 1.60 to 1.30 in the last 10 years. GBP/USD is currently around 15 figures above PPP, compared to an average of 11 figures in the last 20 years. That doesn’t look hugely out of line, but you have to take into account the fact that the US itself is very strong against most major currencies by historic standards. Add to that the fact that the US still looks much the more likely to be raising rates this year, has smaller budget and current account deficits (as a % of GDP), and terms of trade have moved in the USD’s favour with the decline in the oil price (even though GBP is less of a petrocurrency than it once was) and the case for GBP trading above 1.40 seems hard to make longer term, whatever the referendum result.
But it is EUR/GBP where the story is more dramatic. The chart below shows that EUR/GBP PPP has gone form 0.75 10 years ago to around 0.95 now. GBP was further above PPP in 2015 than it has been at any time in the history of the EUR. Now, many will feel that the problems of the Eurozone justify a big premium in GBP. Fair enough up to a point. But the UK’s outperformance of the Eurozone since the crisis has been built on a bigger budget deficit and a record current account deficit. A weak Eurozone will make it difficult for the UK to grow. And if the UK votes to Remain the problems of the Eurozone will remain the UK’s problems just as they are now. Paradoxically, it would be easier to argue for a big premium for GBP if the UK voted “Leave”. At least then there would be some case for arguing that he UK could disengage from a sclerotic Europe (although in practice that will always be difficult). If the UK votes to remain, greater rather than less integration argues for less rather than more divergence. In fact, Q1 saw Eurozone growth outpace the UK. I doubt this will continue in Q2, but the relative performances are nevertheless likely to be less divergent going forward.
So while the short term focus on the polls and the vote itself dominate and GBP is likely to gain a little more ground into and out of the poll on a “Remain” vote, I would see such an outcome as a big long term selling opportunity for GBP against the EUR after the initial knee jerk GBP gain to 0.75 or so. A normalisation of EUR/GBP would become all the more likely, especially since the UK will likely suffer some political instability as Conservative party infighting continues after the vote. EUR/USD and particularly EUR/JPY are also likely to gain, as the EUR has suffered from concerns about the impact a “Leave” vote might have on Eurozone stability, and global risk appetite has also been damaged and is likely to recover, at least initially.
If there is a vote to Leave these pairs will move in the opposite direction, and the impact on the EUR may be nearly as bad as the impact on GBP. Certainly I would expect both to fall against the USD and JPY.
In summary, GBP is a sell on the news, against the EUR on a Remain vote, after the initial GBP rally, and against the USD on a Leave vote. But EUR/GBP volatility looks too high in the short to medium term, as the fates of the EUR and GBP are likely to be similar whatever the outcome. There may consequently be better value for option players in buying EUR/USD or EUR/JPY options rather than GBP.