The BREXIT issue continues to take center stage this week. Recent polls though have eased concerns over Britain's potential exit from the European Union (NYSEARCA:EU). It is not surprising then that risk assets have been rallying. The S&P 500 has edged higher for a second successive day. Meanwhile, volatility has come down significantly as the chart for VIX below shows.
UVXY Drops Sharply
Early last week, volatility spiked as polls showed that the Leave campaign in Britain had a slight edge. By the middle of last week, the Leave campaign had been gaining momentum, leading to a sharp pullback in the British pound. The price chart for the ProShares Trust Ultra VIX Short Term Futures ETF (NYSEARCA:UVXY) shows the sharp rise in the ETF last week.
The Leave campaign though lost momentum late last week following the tragic death of Labor MP Jo Cox. In fact, I had predicted the Leave campaign losing momentum due to the tragic incident in my ETF Strategy report.
The question is whether calm has returned to the markets for good. The case for betting on UVXY has certainly weakened since the start of this week but two days before the vote, I expect markets to remain nervous even though the Remain campaign has an edge. Remember that the advantage for the Remain campaign is not significant.
On Monday, two polls showed that Remain campaign had recovered some lost ground. A third poll though showed that the Leave campaign was slightly ahead. Two days before the crucial vote things are still uncertain although there is a slight edge for Remain campaign. Irrespective of the results, which will be declared on Friday, I expect volatility in the next two days to spike. UVXY therefore could see some gains in the near term after the recent correction.
Bubble In Bond Market
Treasury yields are near levels last seen in 2012. Yields on German and Swiss government bonds, meanwhile, are now in negative territory. Investors are rushing to the safety of government bonds amid BREXIT. But what we are witnessing in the financial markets is unsustainable. In fact, the smart money is already turning negative on bonds. Should Britain vote to stay in the EU on Thursday, we could see some money being pulled out from safe haven assets. I believe that the ProShares UltraShort Lehman 20+ Year ETF (NYSEARCA:TBT) is worth a look in the present environment. In fact, as BREXIT worries have eased somewhat this week, TBT has already been gaining some momentum as the chart below shows.
But the upside could be even more significant, if the Remain camp wins in Thursday's referendum.
UNG Due For Correction
Natural gas prices have rallied over the past one month as the chart below for the United States Natural Gas Fund LP (NYSEARCA:UNG).
The recent gains in natural gas were anticipated. As I had noted in my article last month, natural gas production has been leveling off. This combined with predictions of a hot summer has led to a rally in natural gas prices. The short-term rally notwithstanding, I remain bearish on natural gas. A look at the table below for weekly natural gas storage data from the Energy Information Administration (EIA) highlights the weak fundamentals of natural gas.
Energy Information Administration
As the table shows, inventory levels are still well above the five-year levels. More important, the price rise provides producers an incentive to produce more. As I had noted last month, there remains a backlog of wells, which were drilled before 2016. With prices recovering, producers will start tapping these wells, which should push prices lower. I believe that the natural gas market remains fundamentally weak.
Ahead of BREXIT
The next two days are likely to see risk off. Although the remain camp has gained some momentum since the start of this week, there is still uncertainty. In fact, PIMCO continues to assign a 40% probability to BREXIT. With two days to go, volatility could remain high and safe haven assets such as bond and gold could do well.But what happens after the vote and how to do investors position themselves.
If the remain camp prevails, calm will return to the markets although it might create some political uncertainty in Britain given the polarization ahead of the vote. However, the calm could be temporary. This is because we are in an election year. Another major concern right now is the bubble in the bond market, which I noted above. The negative yields in parts of Europe and ultra-low Treasury yields are causing distortions in the financial markets, which could have long-term implications.
In case of a leave vote, VIX could spike on Friday. A leave vote also creates long term uncertainty mainly because Britain will take two years to exit a negotiation from the EU. The terms of the exit are not clear and so are the costs for Britain. But what is certain that is that it will lead to more headwinds for the global economy, which is already facing challenges due to a slowdown in China, fragile recovery in the U.S. and threats of deflation in Japan and the euro zone.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.