The GBP was the second best performing G10 currency in May. The outperformance coincided with a shift in the betting markets which, at their lowest, suggested only a 20% chance of a “Leave” vote in the EU referendum, down from around 35% in late-March. There have also been a number of polls showing an increased lead for the “Remain” campaign.

But the rally was not as aggressive as might have been expected given the large shift in implied probabilities around the referendum outcome. All else being equal we might have expected GBP-USD to have traded around 1.50 rather than 1.46.

However, the probability of a “Leave” vote is not the only factor influencing the value of GBPUSD.

There have been two main forces dominating GBP recently:
1. Politics: GBP pulled up by a larger probability of a “Remain” vote
2. Economics: GBP pushed down by lower UK-US interest rate differentials
However, in our view, politics is now taking centre stage again. The weak non-farm payrolls release on 3 June saw a significant re-pricing of the likelihood that the Fed would hike at its 15 June meeting. The chances of a June hike implied in the rates futures market fell from 22% to 4% after the release. This softer data was also accompanied by various comments by members of the FOMC which hinted that there was too much uncertainty to hike rates in June. With a June Fed hike now off the table, this means politics can once again take centre stage for GBP-USD.

What political risk is priced into Cable?
Before 2016, GBP-USD tracked expected interest rate differentials remarkably closely (Chart 2). However, this year the market has been focused on the EU referendum in the UK and the price of GBP-USD has remained noticeably lower than the level which would be suggested by the historical relationship with interest rate differentials. We estimate the degree of political risk priced into Cable by the gap between the current spot rate and that suggested by the relationship in Chart 2. This now suggests that if the political risk is resolved (after a vote to “Remain”) that GBP-USD would rally by only around 5% from here. 

The closing of the gap in charts 1 and narrowing gap in chart 2 suggest that GBP-USD is at the right price today. However, we believe that GBP-USD will rise further after the EU referendum.
This is because the uncertainty around the referendum has an impact not only on financial markets but also on the real economy.

“Remain” – increasingly in the price but not yet in the data 
Why do we see GBP moving significantly higher from here? Even if the betting markets were to shift to a 100% chance of a “Remain” vote, it would only suggest a move of 5%. The currency market has largely priced in the significant change in sentiment around the referendum In contrast, it is likely that the soft economic data seen recently has been subdued by uncertainty around the UK’s political future. If so, upcoming data will start to factor in the increasing likelihood of a vote to remain. For example, the recent release of UK GDP for Q1 2016 showed a further softening in business investment (down 0.5% q/q, following a 2.0% q/q drop in Q4 2015). The slight uptick in May’s consumer confidence data could be an early sign of this realignment taking place.

Eoin Treacy's view

Here is a link to the full report. 

The uncertainty relating to the outcome of the Brexit vote in less than two weeks is beginning to take a toll on stock markets as investors begin to hedge their exposure. 

As the above piece highlights, the most common view among commentators is that the vote is similar to that taken in Scotland last year where there was a great deal of emotional debate ahead of the decision but ultimately voters decided to go with the devil they know. 

This piece written by the 22-year old nephew (Tiernan Lean) of a subscriber highlights some of the most pressing arguments espoused by the leave campaign. These are legitimate considerations and even in the event the UK decides to stay the issues relating to democratic accountability, sovereignty and immigration policy raised in this debate will need to be addressed if the EU is ever going to realise its ambition of a united Europe. 

It has surprised me that market participants have been so blasé about the risks associated with this vote since a referendum of this nature represents a wildcard where at least a hedge is appropriate even if the most likely scenario is for the ‘remain’ camp to win. 

The FTSE-350 Index formed a downside weekly key reversal from the region of the 200-day MA and potential for a further test of underlying trading can be given the benefit of the doubt in the absence of a clear upward dynamic. 

The Pound also encountered resistance, against the Dollar, in the region of the trend mean this week and we can expect additional volatility ahead of the vote. 

There is a definite ‘risk-off’ tone to trading action at the end of this week so Eurozone and US markets are also pricing in additional risk. The Euro STOXX Index confirmed resistance in the region of the trend mean today to reassert the medium-term downtrend and a sustained move above it would be required to question the downward bias. 

The S&P 500 Index has at least paused in the region of its all-time peak and potential for the short-term overbought condition to be unwound is looking more likely than not.