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The implications of a possible Brexit are increasing pressure on the eurozone’s much maligned currency. Having been at the mercy of the dollar’s fluctuations for most of the year it is vulnerable to a market that, already sceptical about the durability of the euro, sees in Brexit a path that could lead to the unwinding of the vaunted European project.
“That could be the real legacy of Brexit,” says Jane Foley, G10 currency strategist at Rabobank.
Just as implied volatility on sterling options has risen sharply in the weeks leading up to the June 23 referendum, so the premium for euro options is climbing.
Meanwhile, peripheral sovereign bond yields are widening over that of the 10-year Bund, and the trend in the euro shows a decline against several of its peers, including the dollar, the Swiss franc and the yen.
This marks a reversal from the euro’s steady ascent for much of this year when the single currency was driven higher by a combination of a weak dollar and doubts over European Central Bank policy.
“I always thought the focus would be primarily on the UK, but if it’s an Out vote the implications for the euro are quite dire and more long term,” says Alan Wilde, head of fixed income at Baring Asset Management.
Just as sterling has tracked the swings in UK public opinion, so the euro may feel the force of a tide of Eurosceptic sentiment on the continent, taking its cue from Brexit.
There are numerous trigger points, starting with Spain’s election next Sunday, followed by the European Commission’s sanction deliberations against Spain and Portugal for missing budget targets, a referendum in Italy on constitutional reform, and next year’s elections in Germany and France — not to mention the ongoing strain of migration on Europe.
“The political risks are not going away,” says Laura Sarlo, senior sovereign analyst at asset manager Loomis, Sayles & Co. Brexit would be “a huge deal for the UK and a big deal for Europe”.
Brexit’s impact in Europe could surface in unpredictable ways, should the Leave campaign turn out to be right and the UK economy defies the doom predictions of some experts.
“The questions will start to be asked about the euro, particularly if the UK economy over the next six to 12 months is seen to be faring relatively well compared to expectations,” says John Wraith, UK strategist at UBS.
“If anti-EU sentiment starts to become more elevated and we see some of the stresses in peripheral bond spreads that we’ve seen in the past, the focus will turn back to Europe and the euro will come under pressure.”
How might the ECB and other central banks respond? A sizeable fall in sterling may look troublesome for the UK, but if there is a silver lining it will be the competitive boost a weaker pound gives to UK exporters. That, in turn, puts pressure on other currencies.
“The flipside of UK exporters being in a better place is that eurozone exporters will find life harder, and it’s one reason to think the euro will fall further in due course,” says Mr Wraith. “The eurozone is the most obvious place where they might feel they need to do more.”
It is not hard to see how Brexit could trigger a return to beggar-thy-neighbour currency wars, says Mr Wilde, threatening the G20 understanding reached in February at Shanghai to desist from competitive currency depreciation.
Risk-off sentiment has driven the yen to below ¥104 to the dollar, putting huge pressure on the Bank of Japan to intervene to weaken its currency, and a disorderly market reaction to Brexit may give its central bank the excuse to break the G20 accord.
“I feel certain that if push comes to shove, [ECB president] Mario Draghi will cut rates again,” Mr Wilde says. “You shift the parameters for Brussels to go more negative and Japan doing something similar. Will the US wear a stronger dollar? They might have to accept it as a price to pay.”
There are caveats to the idea of the euro weakening much further. “I don’t think the euro is expensive here,” says Ugo Lancioni, currency and fixed-income portfolio manager at Neuberger Berman. “The euro has fallen a lot on a trade-weighted basis.”
Others feel the risk of political contagion in the euro-area is not so serious, since some political events such as the French elections are some way off.
Then there is the resilience of the eurozone. Crises have come and gone. If Brexit happens it may simply be another.
Do not lose sight of a couple of salient facts, says Steven Saywell, global head of G10 strategy at BNP Paribas. One is that the UK is not a member of the eurozone, so Brexit is “not about the eurozone, it’s about the European Union. The market is at risk of going a step too far.”
The second is that like Japan and Switzerland, the eurozone has a large current account surplus. “The natural tendency for these three currencies is up because of their current accounts”, Mr Saywell says. “The euro is a risk-off currency.”