Sterling Volatility Continues to Rise Ahead of the U.K. Brexit Vote
Sterling is under pressure with approximately 2-week to the U.K. referendum vote on whether to stay or go. Volatility in the currency market has surged to a fresh 2-year high with Cable implied volatility testing the 20% level. In general, implied volatility, which is how much the market believes prices will move over the next year, trades near 10%. The quest remains what will actually happen if UK citizens actually vote to go.
If the Brexit camp wins, what will happen is still open to some debate, but most likely David Cameron will invoke Article 50 of the Lisbon treaty. This would set a two-year timetable to agree to terms of departure, which would have to be approved by the remaining EU members with a majority vote. Any parallel negotiations on trade deals that would put the U.K. on par with other European non-EU members, such as Norway and Switzerland, however, would need unanimous approval of all 27 remaining countries as well as their national parliaments. And the European Parliament would have to endorse both deals. The chances of these giving Britain actually better conditions seem relatively slim, as officials will be very weary of setting a precedent.
The political implications of a U.K. exit will be difficult. Dissatisfaction with the EU, but also the Eurozone, is growing. With the focus on the U.K. referendum, the Spanish election on June 26 is getting less attention, but opinion polls suggest that protest parties are gaining strength. While Spain's economy has been outperforming the rest of the Eurozone, unemployment is falling and house sales are rising for the first time since 2008. The threat that part of the reforms that helped to get the country back on track may be reversed is hardly encouraging.
Protest parties are also gaining strength across Europe, both on the right as well as the left. Germany in particular should be concerned about the U.K. leaving the EU as this would show how quickly things can shift. The idea that the ECB was modelled on the Bundesbank is long forgotten, and one-by-one Germany's caveats that were built into the set-up of the monetary union to keep the legacy of the Bundesbank alive and prevent government financing and direct risk sharing are being undermined.
Fear continues to grow and this fear is reflected in the high cost of premiums related to options on sterling currency pairs. When implied volatility of a currency pair increases it becomes more expensive for those who have exposure to the sterling markets to hedge their positions.If you are a UK company that does business globally, you would have exposure to a rising or falling currency. This risk can be substantial and now it costs a substantial amount to hedge. A vote to go, will likely increase this premium adding to the costs associated with leaving the EU.