By Andrew Wilkinson, Chief Market Analyst
According to the Financial Times, few hedge funds are betting on the outcome of Thursday's British EU referendum. Apparently, a poor start to the year has dulled hedge fund traders' appetites to put on potentially losing propositions. Those that are willing to wager a bet on a so-called Brexit are playing the anticipated contagion effect on the wider euro currency area by shorting the single currency. Others are willing to trade around gyrations in implied volatility through the options market.
The fluctuating fortunes of both 'In' and 'Out' campaigns have already made the referendum a highly tradable event. The British pound was the obvious candidate to trade. Having been served notice that the vote would determine the permanent fortune of the British economy, it was quickly priced lower versus other major currencies. Option traders then ramped up volatility readings to price in the potential for huge moves on either outcome. And for those speculators who live and breathe event risk, the volatile nature of this campaign has created a perfect storm. The pendulum-like swings in the fortunes of both camps has made sure of that.
In an article published in The Guardian newspaper this week, legendary investor George Soros predicts a similar 20% tumble in the value of the pound if voters choose to leave the EU. Mr. Soros allegedly donated his September 1992 billion-dollar windfall bet on Britain's ejection from the exchange rate mechanism (ERM) to humanitarian uses.
However, the circumstances 24 years later are vastly different. Late one October afternoon in 1990, the Thatcher government announced that Britain would join the exchange rate mechanism (ERM). The announcement five minutes before the close of London trading gave investors virtually no time to respond to the decision to shadow the Deutsche mark at too high a rate of Dm2.77. In the coming months and as pressure built on the pound, the British government pledged time-after-time that there would be no backing down from this irrevocable decision, the pound would not be devalued and that, without question, Britain would stay within the ERM.
There was no vote. No referendum. No poll across the public. The British economy was at the hands of politicians who did not understand how markets worked, nor the finite nature of the central bank's ability to defend an overvalued currency. Mr. Soros understood far better than all of London's trading desks. He knew better than the government that sterling's ejection from the exchange rate mechanism was simply a matter of time.
Back then, there was massive room below for the Bank of England to slash interest rates and spur economic growth. And while the global economy was already in the gutter at the time, a sizable loosening of monetary policy was the best, yet distinctly unlikely outcome that Britain could have expected. Anticipated inflation failed to materialize, growth surged and boosted employment, wages and sparked a housing recovery.
However, this time around, Britons do not have the luxury of loosening monetary policy, nor is offshore growth strong enough elsewhere to create benefits from a devaluation of the currency. For investors, the current referendum is a much riskier event than the prompt decision to leave the ERM. Few could foresee the positive economic outcome that ensued as a result of easier overall financial conditions during the early '90s. This time the threat of a significant currency devaluation on the outcome of a 'leave' vote feels like an insufficient safety net.
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