Brexit: Tactical G10 trades for settling dust - TDS

Mark McCormick, North American Head of FX Strategy at TDS, suggests that the Brexit vote has created considerable volatility in markets and a lack of clarity on the path forward, and greater uncertainty characterizes the markets.

Key Quotes

“The aftermath has not generated the type of panic that some observers may have expected, but we note Brexit is a slow burn process with uncertainty likely to linger for months. We think this malaise is likely to persist, increasing European economic and financial risks and intensifying the risk premium on European currencies.

Brexit has been clear G10 FX driver of over the past few weeks. Nearly half of the G10 have traded Brexit risks in line with their implied correlation.

Specifically, CAD, SEK, NOK, AUD and NZD returns dovetail nicely with their implied correlation to the Brexit Risk Index. However, a few currencies have deviated from implied returns, suggesting they look expensive against the USD. This group includes EUR, GBP, and CHF, indicating downside risks there. This also suggests that even though GBP has dropped 12.5% in the wake of the vote further declines are likely given how it is trading against our Brexit proxy. By the same token, this shock should weigh on European currencies. Further EUR and CHF declines look likely until this valuation gap begins to close. The JPY is one notable outlier in the sample, which suggests it has not traded on UK risks since the vote.

For G10 currencies, it shows that Brexit risks have focused on European currencies with focus from other G10 currencies fading quickly. Indeed, AUD, CAD, JPY has seen their correlation to the index drop since the Brexit vote while EUR, GBP, and especially CHF correlations have increased relative to the index. CHF saw the biggest recoupling of Brexit risks with the correlation rising 0.80 from the week before the vote to the week after. The CAD has the lowest correlation with the index, suggesting it remains less focused on European event risk unless it becomes a more global event.

Notably, we expect further downside in GBP but also look for EUR to move lower as CHF also underperforms. Indeed, we think Brexit could impact the way the market views this traditional safe haven, suggesting less support for CHF. We also see fresh downside in NOK and SEK since the downgrades to core European growth risk undermining the economies in Sweden and Norway. This favours strategic longs in JPY against European currencies, including EUR/JPY and CHF/JPY. This also favors downside on EUR/AUD and EUR/CAD. Finally, we also like CAD/NOK higher as the oil proxy trade as European uncertainties persist.”