Brexit is just as much a threat to the euro as it is to the pound
Brexit risk is weighing on the pound but it is also an additional reason for avoiding the euro, leaving the dollar to put in a sterling performance
The possibility that Britain might vote to leave the European Union (EU) on June 23, the so-called Brexit, has quite naturally unnerved the currency markets resulting in a slide in sterling but the euro should also be vulnerable.
After all, with those supporting continued UK membership of the EU arguing both Britain and the European Union are stronger together, then both sides must be, by definition, weaker apart.
So while investors might therefore sell the pound on Brexit worries, they might also decide they should sell the euro. Indeed, as Bank of England governor Mark Carney noted on February 23, referendum-related currency market activity had thus far been most pronounced in sterling’s fall versus the US dollar.
In fact there are a lot of reasons why investors might choose to sell the euro, particularly against the dollar.
For example, if Britain votes to remain in the EU, then the concessions that British Prime Minister David Cameron won in Brussels in February come into effect, and if that appears to cement the idea that the UK can take an “a la carte” approach to the EU, it is hardly realistic to expect the other 27 members of the European Union to stick to a set menu.
Italy is already locked in a dispute with the European Commission over Prime Minister Matteo Renzi’s proposed 2016 budget and is pushing for changes in the euro zone’s fiscal rules to allow governments more budgetary room to try and stimulate economic activity.
An attempt to assert national sovereignty is also evident in Hungary’s February 24 announcement of its intention to hold a referendum on last September’s EU agreement, agreed by a majority vote, that member countries should have mandatory quotas for accepting migrants.
On the economic side, euro zone private business activity expanded at its weakest pace for more than a year in February, according to Markit’s Composite Flash Purchasing Managers’ Index survey.
That kind of economic data can only encourage a monetary policy response from a European Central Bank (ECB) keenly aware that its “below but close to” 2 per cent inflation target is currently some distance away.
The ECB may well move to cut its bank deposit rate further into negative territory on March 10 as it seeks to generate some inflation in the currency bloc, notwithstanding that its own top supervisor Daniele Nouy noted last month that, “In its search for yield, the financial sector has apparently ventured into riskier territories, driving risk premia to historic lows.”
If that is not unsettling enough for potential investors in euro-denominated assets, as the ECB heads towards a move into even more negative yields, Switzerland, which was one of the countries to take the lead on this issue, now feels there are limits to their usefulness.
“Interest rates, for example, cannot continue to be lowered into negative territory without at some point precipitating a flight to cash,” said Swiss National Bank (SNB) Chief Thomas Jordan, pointedly choosing Frankfurt, the ECB’s hometown, as the place to deliver his message.
Of course Jordan is also painfully aware that any further moves by the ECB that lend themselves to a weaker euro, including versus the Swiss franc, might necessitate a policy response from the SNB itself.
But the direction of travel of ECB monetary policy, even when the Brexit issue and intra-euro zone strains are ignored, still arguably tend towards making the euro less attractive as an investment destination, particularly in comparison to the dollar.
While the ECB is contemplating going further into negative interest rate territory, investors cannot fail to have noticed that the US Federal Reserve is currently “some ways away from that,” as Fed Vice Chair Stanley Fischer said last month.
In truth, when the Fed held fire on rates in January, Fisher said: “My colleagues and I anticipated that economic conditions would evolve in a manner warranting only gradual increases in the federal funds rate and that the federal funds rate would likely remain, for some time, below the levels that we expect to prevail in the longer run.”
But the bottom line is that investors can therefore still expect to get paid for holding dollars, in stark contrast to the derisory or negative returns on offer in much of mainland Europe and without exposure to sterling-denominated assets where the pound is being buffeted by the uncertainties surrounding a possible British departure from the European Union.
Brexit risk is weighing on the pound but it is also an additional reason for avoiding the euro, leaving the dollar to put in a sterling performance.