This could be the week the UK breaks up with Europe

This could be the week the UK breaks up with Europe

Thursday's vote by the UK on whether to exit the European Union should bring an end to weeks of uncertainty, but markets could very well remain volatile no matter what happens.

There is a wide variety of outcomes expected. The majority view in financial markets has been that the UK will stay in the EU, while many recent polls have shown those supporting leaving the trade bloc have taken a slight lead. That said, markets could still see a major shift in either direction when the results are released early Friday morning UK time.

Even with lots of pre-positioning, analysts say if the vote is to leave, the pound could fall further, stocks and commodities sell off and investors would seek safe havens like gold and bonds. A vote to stay may have the opposite effect, causing a snap back in the pound and risk assets and a sell-off in bonds.

"Markets have become increasingly sensitive to the polls as the gap has closed. We still think the odds are strongest in favour of staying. What that does is it set up a binary outcome where it sets up the potential for a big surprise if they vote to leave," said Paul Christopher, Wells Fargo Investment Institute head global market strategist.

Another big event in the week ahead is Fed Chair Janet Yellen's two days of testimony on the economy before Senate and House committees Tuesday and Wednesday. Little new is expected from the Fed chair, after Wednesday's postmeeting statement and forecasts on the economy and rates.

"It's hard to see her deviating from the press conference she just had. I don't know how [Yellen] go[es] from being as uncertain as [she was] Wednesday to gaining certainty next Tuesday," said John Briggs, head of strategy at RBS.

The Fed this past week rolled back its expectations for interest rate hikes for the next couple of years and signaled it may only have one hike this year. That unsettled markets since the Fed just several weeks ago was indicating it wanted to hike rates this summer. The news was taken particularly hard in the bond market, where yields have been moving into historically low ranges due to central bank easing and concerns about Brexit.

"She'll probably be asked about the international issues and the linkages to the economy, so she might sound a little bit more cautious," Michelle Meyer, Bank of America Merrill Lynch deputy head of economics.

But market focus will most likely be dominated by Brexit. The implications of the vote are difficult to discern, with one European official saying this past week that an exit "could be the beginning of the destruction of not only the EU but also of Western political civilisation."

The Bank of England has warned of risks of recession and threats to financial stability that could spill over into the global economy, and it says sterling and stocks could fall further. The Bank has put contingencies in place in the event it would need to support banks, and it and other central banks are preparing to help maintain stability.

But some in the market see these warnings as overly dramatic, and they say a buying opportunity could open up in markets after an immediate shakeout.

"Given markets have priced in a decent chance of both outcomes, we think reasonably large moves and most certainly some volatility can be expected whatever the result at this stage. One other key point to keep in mind is that if the vote is close, especially with a leave result, we would expect speculation around the possibility of a second referendum. This may not come to pass … but nevertheless, even such speculation could add to volatility in the days after the result is announced," wrote Nomura rate strategists.

Christopher said aside from market reaction, the impact on the US economy would actually be minimal since the UK is not a big trade partner with the US, and there is a two-year period for the UK to work on its exit with the EU. Critics have focused on the arduous task of unraveling the UK's position in the European trade bloc and realigning trade relationships.

There are also varying expectations on how impactful the vote could ultimately be on the structure of the 28-member European Union and the 19-member eurozone, the countries that use the euro. The big fear has been that the British would be just the first to depart the EU, prompting disgruntled core eurozone countries to choose to exit, threatening the future of the single euro currency.

"The UK's been a marginal member of the EU. They've never been an active participant. To pull out of that, I don't think it's a major event," said Robert Sinche, global strategist at Amherst Pierpont. However, if a euro zone country tried to leave, that would be a much bigger deal. "To pull out of the single currency is a huge event," he said.

"I think there is this risk that we pre-positioned for a bad outcome in Brexit. It's in the bond market, and it's in the currency market. I think even if Brexit happens, it's more of a knee-jerk reaction," said Sinche, adding those positions including a near-record short in the pound, would have to be unwound.

If the UK votes to leave, "it could be very negative, but the epicenter would be the UK, maybe some spillover to Europe and little to the US We don't think this is going to be a major factor for the global economy and the US economy," Sinche said.

The vote comes at a time when markets were already testy, with global bond yields falling to record lows and some, such as the 10-year German bund, falling into negative territory. The 10-year Treasury yield fell as low as 1.47 per cent, its lowest since 2012. The 10-year was yielding about 1.60 per cent late Friday.

Stocks were lower on the week, with the S&P 500 down 1.2 per cent at 2,071.

"It's going to take a long time for a separation to be felt," said Christopher. "On a strong negative vote, you could test [S&P 500] 2,000 or a little bit below, at support levels. We think it's going to be a buying opportunity."

Christopher said the 10-year yield could test its all-time closing low around 1.39 per cent. "You could hit that again," he said. "We think investors should stay in the middle of the curve and look for high-quality corporates."

"The interesting thing is we could see the currencies against the dollar moving in different directions, maybe offsetting each other. You could see the pound at 1.30, 1.25 even. You could see the euro weaken but not as much as sterling," said Christopher. The pound was trading at about 1.43 against the dollar Friday.

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