If Britain votes to remain a member of the European Union, the moment when the tide turned against Brexit will probably be remembered as Barack Obama’s London press conference on Friday. With a single phrase Obama demolished the Brexiteers’ most powerful economic argument when he noted, with a friendly but remorseless grin, that if Britain chose to detach itself from Europe it would wait “at the back of the queue” for any special US trade deal. What made this comment so devastating was not so much the economic importance of a US free trade deal, but two other factors. First was the clear implication that no special favors of any kind could be expected from the Anglo-American “special relationship”. Second, and far more damaging, was the chaos and hysteria among the Brexit leaders that Obama’s visit provoked. As expected in February, when London mayor Boris Johnson seized the Brexit leadership, the campaign has begun to degenerate into farce (see Why Brexit Won’t Happen).
The Brexit leaders tried desperately to mount a preemptive attack against Obama’s support for EU membership, first by describing such “foreign intervention” in British politics as “hypocritical”, “offensive” and “blackmail”. But Boris Johnson overstepped the mark by warning in a newspaper column that “the part-Kenyan President” had an “ancestral dislike of the British empire”. And just as other Brexit leaders tried to dissociate themselves from the racist, archaic and paranoid tone of this comment, Nigel Farage, the UK Independence Party leader unhelpfully sprang to Johnson’s defense: “Obama, because of his grandfather and Kenya and colonization, I think Obama bears a bit of a grudge against this country.” To make matters worse, this sequence of post-colonial gaffes climaxed a terrible week for Brexit, which began with Michael Gove, another Brexit leader, saying that he thought the EU’s ties with Norway, Switzerland and even Turkey were too oppressive—and he would prefer to model Britain’s EU relationship on Albania and Kosovo.
The upshot of these public relations disasters is that spread-betting markets on Friday recorded a fall in the Brexit odds from 34% to 27%. The probability for Brexit fell to 20% on Number Cruncher Politics (a sophisticated statistical website similar to Nate Silver’s FiveThirtyEight in the US). And the pound rebounded to almost US$1.45 for the first time since mid-March.
The question now is whether the Brexit campaign can regain some credibility. If not, and the momentum of public opinion continues to shift towards Remain, assumptions in the currency markets about the best way to trade Brexit will have to be reconsidered. Because sterling is bound to move dramatically in one direction or the other after June 23, it offers tempting opportunities for forex traders, especially at a time when other major currencies are likely to remain unexcitingly range-bound.
Yet few investors are taking big positions in sterling, for two reasons. First and foremost, Britain’s opinion pollsters were so discredited in last year’s general election that all predictions of the referendum outcome seem highly speculative—and will remain suspect until the votes are actually counted. Secondly, there is a high probability that at some point a “rogue poll” will appear to give overwhelming support to one side or the other, triggering panic selling or buying. For this reason, even traders who plan to make big bets on sterling generally feel they should wait until nearer the referendum date. They assume that, with polling so unreliable, the outcome will not be properly discounted—and so profitable trading opportunities will persist right up until June 23.
That at least seemed a fair assumption until last week. It now appears, however, that sterling has started to move in line with the referendum campaign. If that is the case, then traders who want to bet on sterling cannot afford to wait until the last moment.
Implications for sterling
Consider the calculation about the forex implications of Brexit presented in The Case For Sterling a few weeks ago. If Britain votes to stay in the EU, the pound will almost certainly jump back into the range of US$1.50 to US$1.65 in which it traded almost continuously between the end of the financial crisis and the start of the referendum campaign—a rise of between 5% and 15% from its average level of US$1.42 last week. If, on the other hand, the voters decide on Brexit, the pound will probably slump by double that amount—to around US$1.15. As detailed in the article above, this asymmetrical outcome can be explained by a simple calculation. When the pound was at US$1.42 a two weeks ago, the probability of a vote for Brexit was roughly 33%, which was half the 67% probability of a Remain win. Sterling’s expected loss from Brexit to balance the market therefore had to be double the gain expected from Remain.
Suppose now that the probability of Brexit has fallen to 25% from 33%. In that case sterling’s loss on Brexit should be roughly three times the gain from Remain. With sterling at US$1.45 the upside to a “normal” pre-referendum level US$1.55 is about 7%. Thus the downside should be about 21%. As it happens, a 21% devaluation would take sterling down from US$1.45 to US$1.15. So the present exchange rate of US$1.45 seems about the right level to reflect the damage last week to the Brexit campaign. But what if the Brexit campaign continues self-destructing? In that case the opportunity to buy sterling very cheaply may not last much longer—and investors who wait until the referendum will miss their chance.