The World After Brexit
Over the last few days, we’ve already spoken with numerous clients about the potential financial and regulatory impacts of the UK’s vote to leave the European Union. As the referendum’s outcome reverberates through the markets, here are a few key notes:
1) What happened in financial markets? The British pound plummeted 12% overnight from Thursday, nearly doubling its worst ever one-day percentage loss that occurred in 1992 when it came under speculative attack and fell out of the ERM – it has continued to fall sharply today. The euro also weakened substantially, while the Japanese yen strengthened considerably as the safe-haven currency of choice (the Swiss franc’s pressure to appreciate was mitigated by Swiss Central Bank activity). Bonds from the US to the UK to Germany rose sharply, anticipating expansionary monetary policy to ward off recession. Crude oil futures fell more than 6% while gold jumped rapidly.
(2) What happens to my current derivatives trades, especially those traded under English Law? Outgoing Prime Minister David Cameron stated Friday that his successor will be the one to trigger Article 50, starting the two-year period (at a minimum) during which the UK will still be a member of the EU. During that time, as ISDA stated in a press release, “the UK vote to leave the EU will not have an immediate impact on the legal certainty of existing derivatives contracts, nor will it require any immediate contractual change or action from counterparties. Once the UK government serves formal notice of its intention to withdraw, the UK will continue to remain a member of the EU for at least two years. During that time, existing European treaties, directives and regulations will remain in force.” The only exception would be if a derivatives contract referenced the referendum’s outcome in a specific provision, a very unlikely scenario.
(3) How is the current market environment for executing/terminating FX hedges? Particularly in GBP-USD and EUR-USD, many forward and option hedges have moved substantially into the money, permitting the possibility of re-striking hedges to realize their asset value. With dramatically heightened volatility and low liquidity, however, there will be much higher credit charges as well as higher discount rates on the PV of any gains. In addition, should the affected currencies rebound and recoup some portion of their losses, the new at-market forward hedges might move into liability territory and require collateral posting (depending on thresholds).
(4) How is the current market environment for executing USD IR hedges? While market liquidity has remained strong, spreads from mid-market rates have increased slightly from pre-referendum levels. However, several market makers have indicated their unwillingness to price at the lower post-referendum rates (the 10-year yield is down almost 25 basis points since Thursday’s close!), but are offering to lock in at pre-referendum swap rates.
(5) What does the referendum’s outcome mean for previously anticipated rate hikes later this year? While no financial projection is certain – GBP-USD was at 1.50 just before the polls closed in the UK yesterday, as markets anticipated that Remain would win, and now stands at 1.3150 – it appears Brexit has resulted in a greatly diminished possibility of any Fed rate hike in 2016. In fact, markets now view with roughly equal likelihood the possibilities of Fed rate hikes or cuts over the balance of the year.
If you have questions about any topics related to today’s risk management environment, please give us a call. We are honored to be your advisor as we navigate these turbulent markets together.