Brexit Risks Rising

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Includes: DRR, ERO, EUFX, EUO, FXB, FXE, GBB, ULE, URR
by: Marc Chandler

Summary

Attack in Brussels adds to the Brexit fears.

PredictIt shows risks of Brexit almost 50/50.

Most participants are not yet prepared for Brexit.

An ill-conceived strategy undermined by mismanagement and bad fortune is increasing the risks that the UK votes to leave the EU in June. Nearly everything that could, has gone wrong for UK Prime Minister Cameron.

While many investors have anticipated the UK would remain in the EU, the increased risks will likely weigh on sterling, with potential for sharp losses. Sterling is already the worst performer among the majors here in Q1. It is from 3.3% which is more than twice the loss of the New Zealand dollar, which is in "second place" with a 1.3% year-to-date loss.

The break of $1.4230 is the first indication of that this month's upside correction is over, and a loss of $1.4180 could spur a move to $1.40. However, barring a dramatic development, investors should be prepared for a retest of the late-February low near $1.3835. Beyond there is the crisis low of $1.35 from early-2009. A move to $1.30 cannot be ruled out.

Today's terrorist attack in Brussels will likely be seized upon by those who want to leave the EU for another reason. While the Brexit camp has been stressing the loss of sovereignty by being a member of the EU, immigration and border controls, have been the central to their arguments. Today's events keep these issues front and center.

News that US President Obama will visit the UK next month may not be as helpful as the remaining camp may have hoped. The US has called for the UK to stay in the EU. Foreign involvement plays to the Brexit camps fear of its loss of sovereignty.

London Mayor Johnson was an EU-skeptic and the only person his formal endorsement of Brexit surprised appears to be Prime Minister Cameron. Those that want to remain recovered. Sterling fully recovered to trade near $1.4500 at the end of last week. The departure of Ian Duncan Smith from the cabinet was another blow, but outside of the timing, Smith was also an EU-skeptic. However, it shows the deepening fissures within the Tory Party.

Osborne's budget last week was a self-inflict wound. Osborne known for his political prowess is being forced to retreat from his budget proposals that are less than a week old. A large budget hole (at least GBP4.4 bln ) needs to be filled. Over the past couple of years, Osborne has had to back down several times. Given the political environment, an uncontroversial budget was clearly desirable, but he failed to deliver. It gave the EU-skeptic IDS the cover to resign.

Osborne had been considered the most likely to succeed Cameron as Prime Minister. Johnson was seen as the most likely Tory challenger. Osborne's budget has seen his support wane. Moreover, the risks of Brexit are increasing. The events market PredictIt has the odds at 45% today.

Although some market participants bought lightened up sterling exposure and may have bought some insurance via options, our sense talking to various participants many have not acted. With the referendum now within the three-month window, more investors should be expected to act. At the same time, we note that speculators bought a record amount of sterling in the week through March 15, and these late longs may be among the first to exit.

There had been some suggestion of proxy hedging of buying the Swiss franc to protect investors from a large drop in sterling. We are concerned that such protection may not be sufficient for many investors. Today gives a small sense of why. It may be better to hold the franc than sterling, but despite today's attack on Brussels, the Swiss franc is slightly lower against the dollar. We recommend that investors who, like us, see the risk of Brexit increasing, take a direct view on sterling, lightening up the exposure, hedging in the forward or options market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.