EU Referendum Watch: GBP/USD slides to 1.40 as Brexit risks mount
Fawad Razaqzada April 6, 2016 8:40 AM
<p>The June 23 referendum on whether the UK should remain in the European Union may still be more than two months away, but investors are evidently continuing to hedge their exposures and largely avoiding UK assets. The FTSE 100 has barely moved in the past five and a half weeks, while sterling has been pounded across the board, falling even against some of the weakest currencies. Against the dollar, the pound came to within spitting distance of the psychologically-important and long-term support level of 1.40, before bouncing back slightly. Meanwhile the EUR/GBP has reached – and now breached – its own psychological level of 0.80, while the GBP/JPY is testing the low from earlier this year of around 155 as we go to press.</p>
The June 23 referendum on whether the UK should remain in the European Union may still be more than two months away, but investors are evidently continuing to hedge their exposures and largely avoiding UK assets. The FTSE 100 has barely moved in the past five and a half weeks, while sterling has been pounded across the board, falling even against some of the weakest currencies. Against the dollar, the pound came to within spitting distance of the psychologically-important and long-term support level of 1.40, before bouncing back slightly. Meanwhile the EUR/GBP has reached – and now breached – its own psychological level of 0.80, while the GBP/JPY is testing the low from earlier this year of around 155 as we go to press.
But in recent days, it appears as though Prime Minster David Cameron's campaign to warn voters about the dangers of leaving the EU is beginning to work. According to a Telegraph poll, the "remain" campaign now has a narrow lead. Of those surveyed, 51 per cent would now vote to remain, which is an increase of 4 per cent from last month. Meanwhile the exit support has dropped 5 points to 44 per cent. However, the UK polls should be taken with a pinch of salt given their accuracy, or lack thereof, during the Scottish referendum and the general elections. Hence, or otherwise, the pound has barely shown any positive reaction to the slight change in the polls. The public opinion can and will change as we get closer to June 23 and as both sides try to win support of those who have yet to make up their minds. Ultimately it will be the actual vote that will count, not the polls. This could well be a lot different to what the polls currently suggest.
But the risk of "Brexit" is very high if the opinion polls are correct and this is exerting extreme pressure on the pound. Unless we see a dramatic change in favour of the stay campaign soon, the pound is unlikely to make a significant comeback until at least after the outcome of EU vote becomes clear. That being said, the potential for further downside may be limited, too, as surely some of the risks of Britain leaving the EU is already priced in. So a short-term bounce at around 1.40 would not surprise us.
Meanwhile there’s been so much said about the spike in implied options volatility in the pound-dollar exchange rate, with three-month risk reversal spiking to levels higher than even the global financial crisis. This obviously underlines concerns about Brexit risks and investors are evidently taking proactive steps to protect themselves against further sharp falls in the pound. But the spike in volatility may also mean that investors are buying call options, giving them the right but not the obligation to buy the pound at these depressed levels at some future point. Obviously this group of investors do not expect Britain to leave the EU and are therefore looking for a sharp relief rally to make a potential profit. Either that or they are sellers in the spot market and are looking to hedge their exposure but do not want to close their shorts in case the pound falls further. So the rise in volatility is not necessarily a bad thing, but it does make Brexit risks plain to see.
But as the pound falls, the risk of a sharp short-squeeze rally increases by the day. This does not necessarily mean it is time to buy the pound and hope it will recover significantly. Rather, the sellers may wish to proceed with extra care. No doubt, there will also be some decent bear market rallies in the GBP/USD from time to time until June 23. These should provide plenty of long trading opportunities. But the bulls will need to be nimble as they will be going against a very strong bearish trend.
Technical outlook: GBP/USD
The monthly chart of the GBP/USD shows that the Cable is trading near a significant long-term support area of 1.40, where it repeatedly found significant support in the past. This level had momentarily broken down on an intra-month basis such as in 2001 and 2009, while in February of this year it was taken out by a monthly closing basis. But there was no follow-up selling; consequently, the GBP/USD rallied to form an inside bar formation in March. However so far this month, there has been no follow-through in buying momentum either. If the low from last month breaks then this would be a bearish long-term outcome, in which case a drop towards the 2016, 2001 or 2009 lows at 1.3835, 1.3885 and 1.3500 will become highly likely. Conversely, if the high of last month breaks – barring a potential inside bar failure at around the 1.4675-4835 resistance area – then a significant rally could resume.
Zooming in on the daily chart, in figure 2, and we can see that the neckline of the Head and Shoulders pattern around the 1.4055-80 area has been taken out today. The GBP/USD still needs to end today’s session below this area to confirm the breakdown. If seen, that would be a further bearish outcome in the short-term outlook. But, again, the importance of the 1.40 level overrides any short-term technical patterns in my view. For this reason, we should take the latest development with a pinch of salt. Indeed, there is even the possibility that the GBP/USD is in the process of forming a more-significant inverse Head and Shoulders pattern around the 1.40 level – see the shaded area on the daily chart. If the GBP/USD rallies back above the broken support area of 1.4055-1.4080 then there is a possibility that today’s candlestick formation would turn into a hammer or a doji pattern, which would point to more gains in the days to come. The key resistance that the GBP/USD would then need to break is at 1.4170, previously support.
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