Sterling to rebound if Remain vote wins

This article is part of
EU Referendum – May 2016

“While the currency movement may not be entirely attributable to Brexit fears it is a major contributor – when Boris Johnson declared his Brexit decision the pound fell almost 2 per cent, the biggest one-day fall since 2010,” Mr Tulloch says.

“As the uncertainties surrounding the referendum undermine UK economic growth, it is worth considering what the economic consequences of any future result might be. In the event of a pro-EU result, a positive market reaction would be expected as investors’ fears are allayed, with a reversal of the sterling versus euro trend seen in the past few months.

“The extent of any bounce back is itself difficult to gauge, but given the level that sterling has fallen from in such a short period a definitive move following the result [would be expected]. A strong rebound in the market might be expected where pent-up demand is subsequently released following a holding period.”

EdenTree Investment Management’s Robin Hepworth, manager of the Higher Income fund, suggests there is a sense of growing confidence the UK will vote to stay in the EU, and sterling’s implied volatility has dropped as polls show support for the Remain camp firming up.

“With sterling close to a 30-year low versus the US dollar, the risks of a Leave vote appear mostly priced in and a recovery in sterling therefore appears more likely,” explains Mr Hepworth.

“This scenario will favour companies with sterling-based revenues and assets as the pound recovers some of the steep falls seen in recent months. It will also favour UK firms that are significant importers, such as retailers. It would also be a positive for overseas companies with large exports to the UK, though there will not be many of these.”

Economic projections: Risks to sterling

The National Institute for Economic and Social Research’s economic review for May 2016 included a number of projections and research into the near-term implications of a Leave vote, including the effect on sterling. In the paper ‘The short-term economic impact of leaving the EU’, the eight authors note: “Heightened risk and uncertainty will cause sterling to depreciate by around 20 per cent immediately following the referendum, which will result in an intense bout of inflationary pressure.”

It adds: “[A vote to leave the EU] will widen the risk premium associated with sterling. The question is by how much? To calibrate our shock, we look to the options-implied, three-month sterling volatility. This series rose sharply on the day that the three-month contract first encompassed the date of the referendum, and remains elevated. Comparing this increase with that observed in the recent financial crisis we observe that it has been roughly two-thirds of the size.”

Therefore it models the shock to the exchange rate risk premium by scaling the effect that occurred in the fourth quarter of 2008 by two thirds. “The shock then decays by 50 per cent a quarter. It reaches zero by the end of 2017 so that by the time the negotiating window [to leave the EU] has been concluded the sterling risk premium has returned to its baseline level,” the report adds.