A Brexit Currency Domino Effect

| About: CurrencyShares Euro (FXE)

The British pound is headed lower. That is now a forgone conclusion. Leaving the EU will cause a negative economic multiplier effect for Britain as investment flows are likely to diminish dramatically in the months ahead, until the uncertainty is cleared up. Ultimately, a lower British pound could stimulate the British economy in the long term, but over the next year or so, the British economy could get quite a bit messier.

British Pound versus United States Dollar - Monthly OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The British pound - or "cable," as traders like to call it, harkening back to the days when currency quotes traveled via telegraph cable on the bottom of the Atlantic Ocean - registered a rather peculiar trading pattern - an outside-down month. In June the GBPUSD exchange rate traded well above the May highs to reach $1.50155 and then it declined well below the May lows to reach $1.32278. What is extraordinary is that the June monthly range (so far) is also the overnight range on June 24th, the day after the Brexit vote.

From a historical perspective, such wide daily ranges are rare, but in this case they seem appropriate for a watershed event like Britain voting to leave the European Union. Cable is likely to get weaker in the months ahead as Scotland could hold a second independence referendum, which this time may succeed.

The GBPUSD exchange rate was under significant pressure before the first Scottish independence referendum, but with Scots voting 62% to 38% to remain in the EU last week, the pound could be under even more pressure at the time a second such Scottish independence referendum is held. The messiest outcome for the British pound would be if the Scots hold their independence referendum before Britain officially leaves so Scotland can remain in the EU. While this may sound like a bandaid solution, it should put even more pressure on the British pound due to numerous uncertainties concentrated in a short period of time.

It is ironic that an EU proponent, George Soros, had something to do with the events that catalyzed the now-successful Brexit. Great Britain withdrew from the European Exchange Rate Mechanism (ERM) on September 16, 1992 after pressure from speculators (like Soros) forced it to abandon the inflexible exchange rate, a "dirty peg" of sorts. George Soros made over £1 billion by shorting the pound that year. Pragmatic people like the Brits are highly unlikely to have upheld a Brexit referendum if the banknotes in their wallets last week were euros, but that would have been the case if they had stayed in the ERM.

British Pound Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I have a high degree of conviction that the pound is likely headed somewhere into the $1.20s and will get there faster if the second Scottish independence referendum is called expeditiously. Cable has been as low as $1.05 in 1985, which arguably was an extreme level. While markets gravitate towards an equilibrium level near their intrinsic value, they can deviate substantially from equilibrium and reach previously unheard-of extremes.

The disintegration of the UK (by Scotland leaving) or the EU (by more countries leaving), or both, would be the type of events that could provide the necessary level of uncertainty to reach extremes for the GBPUSD exchange rate, and the EURUSD exchange rate for that matter.

If Brexit and a potential Scotland exit (Scotchit?) are bearish for the pound, they are also clearly bearish for the euro and bullish for the U.S. dollar. While Britain never joined the euro, any more eurozone countries leaving the EU would put a serious strain on the common currency. It is true that the euro was only introduced as a currency in January of 1999, but historical exchange rates of the previous currencies going back much further can be modeled to create a synthetic euro using the exchange rates under which they were folded into the common currency - including the Deutsche mark and the French franc. Using such a method, we can see that when the pound was at $1.05 in 1985, the extrapolated electronic predecessor of the euro went below 70 U.S. cents!

United States Dollar Versus Euro Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

While cable was the first to decline after Brexit, and it will be under the most pressure from a short-term perspective, I have great difficulty seeing who will want to hold euros if some Eurozone countries start leaving. I do not believe that euro-dollar parity (1:1) will hold as support. I wrote previously that the euro would fall to parity based on the deflationary pressures in Europe, even without Brexit. Brexit simply means that the euro will decline faster towards parity with the dollar.

This Brexit currency domino effect means that it is only a matter of time before the U.S. Dollar Index breaks out above 100, which has been the recent round number resistance level. As the euro comprises 57% of the U.S. Dollar Index, the extrapolated EURUSD exchange rate and the U.S. Dollar Index look almost like mirror images of each other. They are not quite the same, though, as the British pound is the third largest component of that index (after the euro and yen), at 11.9%.

United States Dollar versus Japanese Yen - Weekly OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The only currency component of the U.S. Dollar Index that is acting like a "fish swimming against the current" is the Japanese yen. Yes, the inverted chart (above) seems to be declining, but a lower number translates to fewer yen per dollar (i.e., a stronger yen). USDJPY traded all the way to 99.075 on Friday, so technically the 100 USDJPY target mentioned here on multiple occasions has now been reached. The trouble is, I don't know how far below 100 the yen will "rally," but I know that it can.

I don't think that this move in the yen is over, as we are in risk-off mode and the massive synthetic short position against the yen - caused by its popularity in carry trades due to years of low short-term interest rates - is now creating a short squeeze. Those carry trades are being unwound, as interest rates are collapsing globally and it is too dangerous to hold some risk assets, despite the cheap yen funding costs.

While Brexit is not as bad as the Lehman Brothers failure in September of 2008, which catalyzed but did not cause the greatest financial crisis in living memory, the effects of this referendum should continue to play out against the pound and euro if Scotland leaves the UK and/or other countries choose to exit the EU.

When the Yellow Dog Barks

And in that regard, here's a bit of advice for the 'no consequences' bunch as they prepare to explain away gold's rise. They've done an excellent job of perpetuating the 'we're running out of oil!' meme in order to disguise the link between excess money creation and higher oil prices. With gold, start with the line that 'gold is reflecting increased prosperity, so higher gold prices are a good thing.' When that gets old, trot out 'gold is an ancient, barbarous relic.' As the desperation builds, try 'it's unpatriotic to own gold.' Eventually, establish a mantra that 'gold is the currency of terrorists.' And when there are no more pages in the script, conjure up FDR's spirit for advice on what to do next.

-- When the Yellow Dog Barks, from The Cunning Realist blog, December 8, 2005

The Cunning Realist was a pseudonym for an asset management professional from New York City who used to post regularly on his eponymous blog with the tagline "an oasis in a world of hacks, hustlers, and hired spin." Although I do not know this person, it is my judgment that he had a deep understanding of the world of finance. Regrettably, he stopped posting in 2012, just as demand for no-spin commentary was most needed. The Cunning Realist had substance in his writing. He chose to use his First Amendment right anonymously, as many of the things he said would undoubtedly hurt him professionally. I understand that well.

United States Dollar Versus Gold Price Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I cited his post on gold from 10 ½ years ago as on Friday something very rare happened. Both the U.S. dollar and gold bullion went up a lot - at the same time! Typically, they move inversely but Brexit caused such a domino effect in financial markets that both rose dramatically (see the very right side of the above chart).

If the Brexit repercussions are somewhat orderly, I do not believe that gold and the U.S. dollar can continue to rise in unison, given their inverse relationship since Nixon took the U.S. off the gold standard in 1971. If those repercussions are disorderly, they could continue to rise in tandem, short-term, so any coincidental rally of the dollar and gold bullion will be a good "tell" as to how smoothly Brexit is progressing.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

Disclaimer: Please click here for important disclosures located in the "About" section of the Navellier & Associates profile that accompany this article.