Article / 27 June 2016 at 7:59 GMT

FX Update: Market seeks post-Brexit focus

Head of FX Strategy / Saxo Bank
  • FX markets absorbing last week's Brexit shock, but volatility subsiding
  • Market getting quite technical in wake of Brexit vote 
  • BIS said central banks will cooperate to maintain financial stability
  • Risks UK could lose AAA rating
  • Tough negotiations lie ahead as next step in Brexit process
  • USD acting as chief safe haven, together with JPY

London and the Houses of Parliament
 FX markets are in "What's next?" mode after last week's Brexit shock. Photo: iStock

By John J Hardy

Volatility is settling rather quickly after last week’s dramatic Brexit vote and the shock it gave to markets. Overnight Japan’s equity market bounced some 2%, and the action in GBPUSD was entirely within Friday’s range, though the trading range was very large for an Asian session. A similar observation applies to EURUSD and most other currency pairs. 

The Bank for International Settlements said at the weekend that central banks will cooperate to shore up financial stability. Japan’s rhetoric on intervention escalated once again overnight. 

Reading through this morning’s comments, some are focusing on the UK’s likelihood of losing its AAA status, after Moody’s shifted its outlook on UK sovereign debt to negative. This supposedly could prove a boon to Australian bonds, for example, as the list of AAA-rated sovereigns shrinks. I don’t buy this argument for the long haul as Australia will be beset with sovereign debt problems once the credit cycle Down Under peaks and is in retreat. But if AUDUSD does manage to rally to new local highs, this is likely a key driver.

The focus now is on the next steps in the Brexit process, with a European Union summit scheduled for tomorrow and Wednesday, with UK prime minister David Cameron to attend the first day's meetings but with the UK excluded from the second day's proceedings. 

The formal step that gets the Brexit ball rolling is invocation of Article 50, which removes the UK from all influence and decision-making as negotiations (supposedly taking up to two years, but can be extended) on the terms of the new relationship get underway. Things won't be easy for the EU. The Czech foreign minister said that European Commission president Juncker should resign, calling him a “negative symbol” for the EU. Austria’s Freedom Party leadership did him one better and called for the resignation of both Juncker and European Parliament president Martin Schulz.

The second Spanish election in six months failed to yield a dramatically different outcome from the previous vote and doesn’t immediately fan the flames of EU skepticism. The People's Party improved gained 15 seats (137 out of 350), and caretaker prime minister Mariano Rajoy has demanded the right to rule. The anti-austerity Podemos party only picked up two additional seats to reach 71. Peripheral EU spreads are orderly and sharply back lower after a tremendous post-Brexit jump on Friday.

This week will have a distinctly political focus, and raw sentiment swings will drive most of the market action. But also look for a transition to increasing focus on economic data starting with this Friday’s key manufacturing surveys.

The market getting quite technical in the wake of the Brexit vote as the intraday action on Friday settled around the 38.2% Fibo retracement area, and the subsequent selloff was collected at a typical “throwback” 76.4% Fibo. When markets are volatile and uncertaint, Fibonacci levels gain prominence, so watch for this to remain the case for now.
The G-10 rundown

USD – Acting as chief safe haven, together with the JPY, from EU existential worries and sterling turmoil. Interesting from here to see how the market treats US data at the end of this week, with PCE inflation out on Wednesday and ISM manufacturing on Friday.

EUR – Maintaining strength versus sterling as EURGBP is a key barometer for the point at which Brexit worries transition more into a general EU existential risk trade (or simply when and if the world decides that the sterling discount is sufficiently large).

JPY – a safe haven as long as risk sentiment is weak, but the market is also very wary of official intervention and with good cause. Owning volatility through options and fading bounces with hedges is one way to trade this, though we certainly prefer trading free markets. (i.e., long JPY cross calls after bouts of JPY strength and then dynamically shorting spot against intervention spikes, taking profit on hedges and hoping to rinse and repeat.)

GBP – the longer it takes to post new lows in the key sterling crosses, the more likely we get caught in a treacherous range of churning as the market absorbs the impact of what happened last week – i.e., the market may want a sense of where the UK activity numbers are headed for July before drawing conclusions. We also have a very heavily positioned market and lack of further performance will wear on shorts’ confidence.

CHF – clearly absorbing safe-haven flows but the Swiss National Bank is actively intervening, so this is not easy to trade, but could offer the same kind of opportunities as JPY pairs for those (unlike us) interested in trading a currency where active intervention is a risk.

AUD – received a blow in line with the sentiment shift and would expect that AUD remains correlated with risk appetite until volatilities have faded.

CAD – USDCAD has pulled back above 1.3000, and the technical situation is rather clear here, as we watch whether the pair can clear 1.3180+ and charge higher to 1.3500.

NZD – same as for AUD, with NZD perhaps a bit more vulnerable than AUD if risk appetite worsens materially.

SEK – we questioned on Friday whether SEK could escape the correlation with risk appetite due to the EU existential risk trade and euro downside potential, but so far lacking evidence that this is the case.

NOK – same comment as for SEK as NOK certainly not acting as a safe haven.

Upcoming Economic Calendar Highlights (all times GMT)
  • US May Trade Balance (1230) 
  • US Jun. Preliminary Markit Services PMI (1345) 
  • US Fed Chair Yellen to speak at ECB event (1730) 
  • ECB President Mario Draghi to speak (1730) 

— Edited by John Acher

John J Hardy is head of FX strategy at Saxo Bank


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