The euro to pound exchange rate (EUR/GBP) is forecast to continue edging higher as foreign investors take out hedging insurance to mitigate against any risks posed by the EU vote in mid-year.
New research from investment bank JP Morgan suggests that continued demand by investors to hedge against Brexit risks ahead of the June 23rd EU referendum will likely keep sterling under pressure.
This demand will continue to pressure sterling regardless of the actual outcome of the poll. This explains the 'Brexit premium' - the gap between where the GBP would be were there no referendum and where it currently is, despite supportive data.
And, if the UK electorate vote to leave the EU it is expected to send the pound an additional 10% to 20% lower.
The news comes in the wake of the latest opinion polls that show the gap between the Leave and Stay camps is incredibly tight.
In fact, the latest polling data from ICM shows the Leave group (45%) is now bigger than the Stay (42%) group, "Most polls continue to suggest that it’s a very tight contest, with neither side able to gain a decisive lead," said ICM's Jennifer Bottomley on Tuesday.
Foreign owners of UK assets stand to lose a substantial amount on their holdings, in the form of currency loss, in such a situation.
Thus in order to mitigate against such a devaluation they have purchased hedges to protect their investments. These normally consist of selling an equivalent amount of pounds as the value of their asset, so that a devaluation will result in no loss.
Given the fairly close contest between the stay and leave camp in polls, the level of hedging is expected to continue rising significantly:
“We remain squarely focused on the likelihood of continued GBP depreciation ahead of the EU referendum on June 23 as non-residents hedge UK exposure against the uncertain consequences of Brexit,” argue J P Morgan analysts, Meggyesi and Anthonj.
In fact, it is possible that hedging could reach levels which might “overwhelm” the exchange rate, since the gross level of assets - or “foreign liabilities” as they are called - which could be hedged is between 400 and 500% of GDP:
“The gross foreign liability position is over 500% of GDP and still in excess of 400% of GDP once the FX-liabilities of UK banks to non-residents are excluded. Given this balance sheet position, even a trivial increase in hedge ratios has the potential to generate sizeable GBP supply.”
Since over half of foreign liabilities are owned by investors in the Euro-zone the main currency pair affected by hedging flows is likely to be EUR/GBP.
“Roughly one-half of these assets are held by European investors, as a result of which we expect a substantial amount of GBP hedging flow to be channelled through EUR/GBP and not just cable.”
JP Morgan point out that the official referendum campaign is set to start on April 15 and that the amount of extra hedging which happens will be heavily dependent on the extent to which either of the two opposing camps make inroads into the large share of undecided votes:
“Key for GBP will be whether the official campaign makes any inroads into the still relatively large group of Undecideds who currently average 20%. Bookmaker odds for Brexit are also relatively steady between 30-35%.”
Their base case scenario, however, is that the UK will remain within the EU (60% probability) and that sterling will recover following the win for Bremain, rising to 1.50 versus the US dollar and pushing EUR/GBP lower to 0.76-76.
At the time of writing the euro to pound sterling exchange rate is quoted at 0.7973.