There is now only a week left until the EU Referendum on Britain staying within the European Union and uncertainty regarding the potential outcome is causing some areas of financial markets to trade at what can be considered “stressed levels”. Indeed, many central & commercial banks have been spending time over recent months contingency planning in case there is a BREXIT. How big an event BREXIT will be is hard to say but one can look back to September 1992 when England pulled out of the Exchange Rate Mechanism (ERM) for guidance on the potential impact on financial markets. Admittedly, pulling out of the ERM was probably a bigger issue than BREXIT is today due to the currency linkages that were enforced within the ERM.

When Britain pulled out of the ERM (16th September 1992), the GBP/USD exchange rate moved from approximately 2 USD per British Pound to 1.70 USD per GBP within the first week and by the end of the month was at 1.50 USD per GBP. Against the Deutsche Mark (for those old enough to remember it) the rate went from 2.80 DM per GBP to 2.40 DM per GBP within three weeks. Government bond markets were also buffeted in various directions as initial Bank of England reactions led to the announcement of a 5% increase in interest rates which put upward pressure on bond yields but this was then offset later that same day when interest rates were returned back to 10% as Britain pulled out of the ERM. Within the first month after sterling’s departure from the ERM, UK 10yr government bond yields fell from 9.40% to 8.90% and by November had moved even lower to 8.00%. However, the economic headwinds faced by the UK economy continued to push the yield on 10yr government bonds to a low of 6.00% in December 1993. Excluding any knee jerk intraday movement, equity markets also reacted positively to Britain leaving the ERM, rising 15% within the first month and a further 15% by the end of March 1993.

Most people already know of how George Soros and his Quantum fund benefitted (and identify him as the trigger) to this event. He even earned the title “The man that broke the Bank of England”. However it is unknown how big the Quantum fund was at the time (Soros borrowed approximately 6 billion pounds to be able to place the various trades in financial markets), but it would be fair to say that it was not as big as some of the hedge funds that exist today. This is why many central bankers in Europe are particularly concerned about the BREXIT vote and are preparing their institutions in case some type of intervention is required. Their job seems to have been made even more difficult by the very thin liquidity observed in financial markets as we approach the EU referendum on 23rd June. This same thin liquidity was a contributor to the flash crash in US government bonds in October 2014, the flash crash in equity markets in May 2010, and the collapse in the Euro-Swiss exchange rate when the Swiss National Bank abandoned the EURCHF peg in January 2015.

The illiquidity in financial markets is likely to get worse over coming days as market participants step back and reduce risk taking ahead of this crucial referendum. This therefore means that financial markets are susceptible to large movements on every bit of new data released no matter how unjustified it may be. Signs of this were observable this last Friday (10th June) when at 6pm London time results from a BREXIT poll were released showing ‘the leave’ supporters had a 10% majority over ‘the remain’ supporters and thus GBPUSD spiked lower from 1.435 to 1.418. The poll was only based on 2000 people so hardly definitive but it still had a sizeable impact.

If Britain leaves the EU, there is likely to be an initial reaction to the news and a longer term reaction based on evolving economic fundamentals (Mr. Soros’s trade captured both of these). Based on current market movements and reactions to news flow, the initial response should be a weakening in GBP against other major currencies. A small part of this seems to have already been priced in with GBPUSD moving from 1.47 last month to 1.42 and I would hazard a guess than on a BREXIT vote it could trade down to the 1.35 – 1.30 region within a very short time period. This move could extend lower over the following 12 months if economic uncertainty and a possible UK recession come to the fore.

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