On 20 February 2016 prime minister David Cameron announced the date for a referendum on the UK's membership of the European Union, in an attempt to settle once and for all the festering sore that for the past 26 years been a constant irritant to every Conservative party leader since Margaret Thatcher.
The UK has always had an uneasy relationship with respect to European influence over its affairs and this relationship wasn’t helped in the middle of the last decade when the UK public were denied a referendum on the Lisbon Treaty, after initially being promised one.
The fact that the French and Dutch managed to obtain just such a referendum which they rejected in 2005 only to see the treaty pushed through via the backdoor only served to reinforce that unease and distrust, which has continued to grow on the back of the Eurozone debt crisis, and the EU’s reaction to it.
This distrust finally saw voters get their wish for a plebiscite as the Conservatives made good on their promise in their recent election manifesto.
In granting the public their wish the Prime Minister having won one referendum in Scotland, obviously felt confident enough that he could win this one as well. What he probably didn’t anticipate was that this pledge could blow up in his face as could well happen later this week when UK voters get the opportunity to vote in what is likely to be a seminal moment not only for the UK but also for Europe, as we go to the polls to vote on the country’s future relationship with the EU.
Putting to one side the toxicity of the debate the reaction of financial markets thus far has been fairly predictable with sterling selling off though given the hyperbole of some of the warnings the reaction in some sterling related markets has been somewhat counter-intuitive.
UK gilt yields have fallen as investors have piled into UK government bonds, pushing UK government borrowing costs to their lowest levels in years.
While the pound is down on its trade weighted index by about 10% since the middle of last year it’s only slightly lower than when the February announcement of a vote was made, which rather begs the question as to whether some sterling weakness is priced in already.
As we head towards the “Brexit” vote we’ve heard all manner of apocalyptic outcomes for sterling declines in the event of a “leave” vote, with some estimates of declines of in excess of 20%.
While one can never say never about a particular outcome this would be more than the sterling decline in the wake of the surprise ejection of the pound from the ERM in 1992, an event that no one expected and would we were told if it happened be negative for the UK’s prosperity.
Ultimately a weaker pound isn’t completely negative which probably explains why the FTSE100’s recent decline hasn’t been anywhere near as heavy as the declines in European markets, with the DAX down sharply, along with the CAC40. This is because a weaker pound helps the UK companies who derive most of their incomes in US dollars.
It’s also important to note that a “Brexit” vote won’t be a zero sum game for sterling with the euro likely to come under significant amounts of pressure as well as investors wonder about the viability of the European project in general.
Dissatisfaction with the EU is also starting to run deep in France and Italy and given that France has presidential elections next year where Marine Le Pen is currently riding high in the polls the risk must be that any fallout from events this week will have an effect with respect to European assets as well.
With markets already concerned about a fragile global economy, a slowing Chinese, Japanese and US economy, the UK referendum is yet another headache that investors could do without.
Volatility is likely to be high this week with GBPUSD, EURGBP, EURUSD likely to be see significant activity while any further weakness in equity markets could well see gold prices and the VIX Volatility index make further gains.
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