Brexit – A currency off an Exit

Suresh RamanathanInterest Rate and FX StrategistPh.D (Malaya), M.Ec. , B.Ec. (Applied Ec. Hons)

19th June 2016

Contact: skrasta70@hotmail.comMobile: 016 3092330

The Political Economy Picture

Decades of Mishaps.

The Background story of Brexit

Sterling Pound underperforms during risk aversion occasions

Sterling Pound’s folly with the Snake – The Black Wednesday of 92

Sterling Pound – A currency for all seasons ?

The UK’s Worst and Best case – A trade deal proposition

Brexit to open a Can of worms across Europe – The aftermath

Referendum Day Timetable

Decades of Mishaps

In 1944, Britain entered into the Bretton Wood managed exchange rate system. This fixed the pound’s exchange value to the US Dollar, which in turn was linked to gold. The exchange rate was set too high for such a damaged economy; thus Britain was forced to devalue the pound by 30% in 1949. But even that was not enough. The next 18 years were characterized by persistent balance of payments problems and sterling crises, Britain was forced to seek assistance from the IMF more than once.

Enter 1967, Britain announced it was lowering the exchange rate so the pound sterling is now worth $2.40, down from $2.80, a cut of just over 14%. The decision came after weeks of increasingly feverish speculation and a day in which the Bank of England spent £200m trying to shore up the pound from its gold and dollar reserves.

Sterling’s fortune in coming years after 1967 was not smooth, more volatility and uncertainty beckoned. In 1971, Nixon suspended convertibility of the dollar to gold, effectively ending the Bretton Woods system. But even after this, Britain continued to prop up the pound against a market that had clearly wished it to be lower. The currency simply did not warrant the value that Britain wished it to have, yet successive Chancellors refused to allow it to float freely, fearing a sterling collapse, as exchange controls were put in place.

In 1976, the Chancellor of the Exchequer, Dennis Healey called in the IMF to help arrest persistent runs on sterling. On the advice of the IMF, the Chancellor imposed austerity measures, which reduced inflation and improved economic performance. The pound recovered but only temporarily. Against a background of rising unemployment, the Labor government of UK was ousted. In 1979, the Conservatives under Margaret Thatcher won the election. 1979 was a turning point for the pound as exchange controls were lifted, and the currency for the first time was allowed to float. The immediate reaction was a weaker sterling.

The Background Story of Brexit

The UK was not a signatory to the 1957 Treaty of Rome which created the European Economic Community (EEC). Further applications were made to join the organization in 1963 and 1967 but once again vetoed by France. A third application was made in 1973 when the UK was administered by the Conservatives, which was successful, as the UK joined the ‘Common Market’.

The opposition, Labor Party, contested the October 1974 general election with a commitment to renegotiate Britain'sterms of membership of the EEC and then hold a referendum on whether to remain in the EEC on the new terms. The1975 referendum to decide whether the UK should remain in common market, witnessed an overwhelming 67.2% yes and32.8% no. It was sealed, the UK will remain in the common market. Attempts were made by Labor in the 1983 generalelections, calling for the UK to leave the common market, but futile. By November 1993, the EEC became the EuropeanUnion (EU) after the Maastricht Treaty.

In 2012, PM David Cameron rejected calls for a referendum on the UK's EU membership, but suggested the possibility ofa future referendum to gauge public support. In January 2013, Cameron announced that a Conservative governmentwould hold an in-out referendum on EU membership before the end of 2017, on a renegotiated package, if elected in2015. The Conservative Party won the 2015 general election. Soon afterwards the European Union Referendum Act 2015was introduced into parliament to enable the referendum.

For foreign exchange market participants, the key would be the impact of Brexit on the Pound Sterling. In the run up tothe referendum on June 23rd, Sterling Pound has been rather wobbly, pricing in the risk of an exit and the subsequenteffects on the general economy of the UK. While this is the base case, the magnitude of sterling pound decline is whatmarket participants are concerned.

Sterling Pound – Underperforms during Risk Aversion Occasions

Past occasions, which witnessed a major decline for the Sterling Pound, include the Global Financial crisis of 2008, incomparing the currency with the relative liquid G3 currencies of Euro, US Dollar and the Yen, the Pound sterling hadunperformed against the Yen the most between August 2007 to December 2009, depreciating by almost 40%. While itsdepreciation vs the other G2 pairs were within the range of 20-25%.

Another significant event, the Scotland Referendum in September 2014, the currency was rather flat vs the EURO and USDollar but appreciated against the Yen by almost 3.5%. During the 2015 UK General Election, the Pound once againappreciated significantly against the Yen by 7% and close to 3% vs the US Dollar but rather flat to the EURO.

There were only two other major events whereby the Pound sterling appreciated significantly vs the EURO, the 2010 UKgeneral elections, between January to June and the 2014 sterling rally in Q2 2014. During these periods, the currencygained by 10% and 5% respectively.

What we note is that the Pound reacts strongly to risk aversion trades when events are global in nature, such as theGlobal Financial Crisis of 2008, where swings for the currency against the G3 liquid currency pairs are pronounced.During periods when events are rather centric to the UK, such as elections, it tends to outperform against the singlecurrency, EURO.

Within the EU, two significant ‘Outsiders in the Inside’ come to mind, Norway and Switzerland. Many British eurosceptics are eyeing Norway and Switzerland and asking whether Britain would be better off outside the EU withNorwegian and Swiss style association agreements, but in often case, these agreements have been tenacious with multipleinstitutional impasse, giving rise to new issues and hurdles to grapple with.

Sterling Pound’s Folly with the Snake – The Black Wednesday of 92

When the ERM was set up in 1979, the United Kingdom declined to join. This was a controversial decision, as theChancellor of the Exchequer then, Geoffrey Howe, was staunchly pro-European. His successor Nigel Lawson, a believer ina fixed exchange rate, admired the low inflationary record of West Germany. He attributed it to the strength of theDeutsche Mark and the management of the Bundesbank.

Thus, although the UK had not joined the ERM, from early 1987 to March 1988 the Treasury followed a semi-officialpolicy of 'shadowing' the Deutsche Mark. In 1990 however Sterling had joined the EU's Exchange Rate Mechanism(ERM) but it struggled to remain inside its designated floating band.

The ERM or also known as ‘ the snake ‘demanded that currencies stayed within a band set in relation to other currenciesin the ERM club. To maintain the currency values relative to each other, countries with the most valuable currencies hadto sell their own and buy the weakest. In September the German Deutschmark was the most powerful currency andSterling the weakest within its band.

Bank of England was furiously buying sterling but little was done by the Bundesbank to sell Deutschmarks. Chancellor ofthe Exchequer Norman Lamont raised interest rates from 10% to 12%, then to 15%, and authorised the spending ofbillions of pounds to buy up the sterling that was being frantically sold on the currency markets. But the measures failedto prevent the pound falling lower than its minimum level in the ERM. By 7:00 pm 16th of September, Norman Lamont,announced Britain would leave the ERM.

Sterling Pound – A currency for all seasons ?

As the debate on Brexit hits fever pitch in coming weeks, what comes to my mind is pricing in the worst case scenario.From a general economic perspective being an ‘Outsider in the Inside’ in the footsteps of Norway and Switzerland,economic and trade relations for the UK with the European Union will be riddled with multiple institutional impasse,giving rise to new issues and hurdles to grapple with. But for the currency itself, which was never part of the singlecurrency in the first place, the ramifications will be critical.

But for those that have witnessed the fortunes of sterling over a longer period of time have a fascination for the resilienceof the currency, why? Because the currency has faced numerous challenges in the past but yet remains one of the most sought after liquid unit after the US Dollar.

The Pound has faced numerous challenges in the past, yet it faces another crucial test on June 23rd. At current juncture, much of the Brexit negativity is being played out in currency markets, but its depreciation has been gradual. For a worst case scenario to be priced in, it is vital in evaluating the long term repercussions of being an ‘Outsider in the Inside’. Would the currency wiggle its way out of this? The jury is still out on this one!

The UK’s Worst and Best case – A trade deal proposition

Based on economic modelling of the trade impacts of Brexit and analysis of the most significant pieces of EU regulation, if Britain left the EU on 1 January 2018, we estimate that in 2030:

In a worst case scenario, where the UK fails to strike a trade deal with the rest of the EU and does not pursue a free trade agenda, Gross Domestic Product (GDP) would be 2.2% lower than if the UK had remained inside the EU.In a best case scenario, where the UK strikes a Free Trade Agreement (FTA) with the EU, pursues very ambitious deregulation of its economy and opens up almost fully to trade with the rest of the world, UK GDP would be 1.6% higher than if it had stayed within the EU.

Brexit to open a can of worms across Europe

Referendum Day Timetable

Polls will be open from 7am to 10pm British Standard Time (BST) on Thursday, 23 June.

It is illegal to publish any opinion/exit polls during the day as long as polls are open for people to vote. Exit polls are allowed to be published as soon as the polling stations are closed, but there are currently no plans by broadcasters for an exit poll as the margin of error is deemed to be too large.

However, Britain’s hedge fund industry is commissioning private exit polls to get an early warning of the result. Electoral Commission rules allow exit polls on the day of a referendum so long as they are not published until polls close at 10pm BST.

When polls are closed, local results will be declared as the counts are completed. The bulk of the results should be in somewhere between 2am-4am BST on Friday morning, depending on how quickly the votes are counted and how close the results are running.

The BBC estimates that it should be possible to make a projection of the result some time around 4am BST.

The Electoral Commission, which is in charge of overseeing the referendum, estimates the final result will be

announced at ‘breakfast time’ on Friday, 24 June.

The Market Picture

Sterling Pound An Historical Overview – Over Four Decades.

Effective Exchange Rate and Sterling Pound – Different sides of the same Coin

Gold – The alternative hedge against a Brexit

Ringgit vs Sterling – the realistic range

Sterling Premium against the US Dollar via Hong Kong Dollar

The regime change - Last man standing against Parity

Trading the Brexit – the initial scalping

Patterning the short Sterling trade

0.5

0.75

1

1.25

1.5

1.75

2

2.25

2.5

2-Jan-75 2-Jan-80 2-Jan-85 2-Jan-90 2-Jan-95 2-Jan-00 2-Jan-05 2-Jan-10 2-Jan-15

Parity GBP/USD =1.00

A 30% decline from current

spot worth 4064 pips

Sterling Pound – An Historical Overview – Over Four Decades

0.5

0.75

1

1.25

1.5

1.75

2

2.25

2.5

70

75

80

85

90

95

100

105

110

2-Jan-90 2-Jan-95 2-Jan-00 2-Jan-05 2-Jan-10 2-Jan-15

Effective Exchange Rate

Sterling Pound (rhs)

Firmer Effective Exchange Rate

Fimer Effective exchange ratebut Sterling Pound remains steady

Weaker Effective Exchange RateWeaker Effective exchange ratebut Sterling Pound remains steady

Effective Exchange Rate and Sterling Pound – Different Sides of the same Coin

0.5

0.75

1

1.25

1.5

1.75

2

2.25

2.5

200

400

600

800

1000

1200

1400

1600

1800

2000

2-Jan-90 2-Jan-95 2-Jan-00 2-Jan-05 2-Jan-10 2-Jan-15

Gold (USD p/oz)

Sterling Pound (rhs) Gold at 1,800 USD p/oz the next alternative to hedge against a BREXIT

Gold – The alternative Hedge against a Brexit

Ringgit vs Sterling – The realistic Range to be between 4.50-5.00

4.0000

4.5000

5.0000

5.5000

6.0000

6.5000

7.0000

7.5000

Apr-05 Apr-07 Apr-09 Apr-11 Apr-13 Apr-15

Ringgit first levels to be hit will be in the range of 4.50-5.00 on the back of BREXIT

Average = 5.71

Sterling premium against USD via HKD shrinking

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00

-5.00

10.00

25.00

40.00

55.00

Jan-77 Jan-86 Jan-95 Jan-04 Jan-13

Sterling Premium against USD via HKD (lhs %)

USD/HKD

GBP/HKD

GBP premium against USD shrinks if Brexit occurs

A regime change – Sterling Pound the last man standing against parity

0.200

0.400

0.600

0.800

1.000

1.200

1.400

1.600

1.800

2.000

2.200

2.400

2.600

Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10 Jan-15

NZD/USD AUD/USD EUR/USD

Parity GBP/USD

Below Parity

against US Dollar

Trading the Brexit – The initial scalping – 2000 points ready to be fleshed

Patterning the short Sterling Trade

GBP/USD

1.440

Intervention driven target

1.340

If Brexit Structural short trades

1.240

1.240 Hit and Run Trades

Expected Initial Reaction

1.000

Disclosure and Disclaimer

This research has been prepared by Suresh Ramanathan . It is provided for informational purposes only. It does not constituteor form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase orsell any relevant financial instrument. The research report has been prepared independently and solely on the basis of publiclyavailable information that Suresh Ramanathan considers to be reliable.

While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as toits accuracy or completeness and Suresh Ramanathan, accepts no liability whatsoever for any direct or consequential loss,including without limitation any loss of profits, arising from reliance on this research report. The opinions expressed hereinare the opinions of Suresh Ramanathan responsible for the research report and reflect his judgement as of the date hereof.These opinions are subject to change, and Suresh Ramanathan does not undertake to notify any recipient of this researchreport of any such change nor of any other changes related to the information provided in this research report.

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