Brexit & the currency wars

February 24, 2017 01:00 PM

The effect of Brexit on the market value of the British pound is well-documented and understood. British citizens voted to leave the European Union and the immediate response in the currency market was a decline of more than 15 percecnt in the pound sterling’s value in terms of U.S. dollars. Perhaps less understood, but much more important to the United States, is the effect of the Brexit vote on the dollar index and potentially on the United States economy. 

A once in a lifetime opportunity

For traders in the futures and options markets, the unwinding of currency connections exposed to Brexit has already resulted in substantial profits and losses. The analysis of what has occurred and what the future may hold is concerned primarily with “currency warfare” – the continuing battle to see which currency can achieve the lowest price. 

The victor at each stage of the battle is able to produce larger gains in export trade, benefitting the home country’s economy. A predictable result following Brexit was that currencies competing with Great Britain in world markets would feel the sting of defeat temporarily, and then they would attempt to fight back by somehow reducing the market prices of their own currencies. 

Suppose you manage a nation’s central bank and your currency is suddenly thrust to a higher price relative to an important trading partner. Your goal shifts to reducing the price of your own currency and the question is, how do you do this? 
An immediate strategy in currency warfare is to use your currency to buy another country’s currency. 

Then the question becomes, which currency should you buy? Because you will be holding the bought currency for a while, the best decision is to buy a stable currency – one that is useful for trading without question worldwide. Your attention immediately centers on the U.S. dollar as your central bank or Treasury department buys massive quantities of dollars. The effect is to increase the value of the dollar and to lower the value of your country’s currency. 

Now suppose that you are a trader of futures and options and predict responses by central banks following an economic event such as the Brexit vote to leave the European Union. Is this the time for a bullish position in U.S. dollars? 

With other countries purchasing dollars and U.S. Treasury securities in an effort to reduce their own currency values, the answer must be “yes.” 

There are two probable outcomes from Brexit that are favorable for the trader. First, you know that there is a strong inverse relation between price changes for the U.S. dollar index and currencies that compose the index. Several of the currencies that are the largest contributors to the Dollar Index are also expected to compete strongly with the British pound to have a lower price. The competitors in currency warfare include the euro, Swiss franc, Japanese yen, Canadian dollar and Australian dollar. 

The pound sterling is also part of the Dollar Index and would normally be included in your trade. However, the pound has already been demoted as a result of Brexit (see “Pound & the Dollar Index,” below). Because of its current low price, any impact of price decline on the Dollar Index has already occurred. Therefore, the pound is not part of the trade.

To take advantage of this predictable situation, you decide to go long the Dollar Index and short on Great Britain’s competing currencies. Several possible trading vehicles include exchange-traded funds (ETFs), futures and options. One bullish security representing the dollar is USDU, a Wisdom Tree Bloomberg ETF. The USDU fund includes the Chinese yuan, which should also have an inverse price movement relative to the U.S. dollar.

The potential price changes for each currency may be measured by the differences in cumulative percentage price changes for the currencies beginning at the first of June 2016. Response to the Brexit vote began on June 24 and ran through the 27th, and following those dates the battle for lower price began as the pound’s price declined. Charts for the six currencies in comparison with the U.S. Dollar Index show the progress of battle as the cumulative percentage price changes are made more negative by the purchase of U.S. securities and dollars, driving the home currency down in value and increasing the dollar index.

“Pound and the Dollar Index,” shows two periods of rapid declines in the pound’s price. The first period, June 22 to July 7, is the time of Brexit and is the initial attack (by vote instead of central bank strategy) by Britain in the new currency war. The second period, Sept. 30 to Oct.14, seems to be a signal to countries with competing currencies to get serious about reducing their prices by purchasing U.S. dollars and U.S. securities (see “Early movers,” above). The trader, aware of what is happening and its causes, begins to buy the Dollar Index and sell the pound’s currency war adversaries: primarily the euro, Swiss franc and Canadian dollar. The Australian dollar and Japanese yen weakened versus the dollar more substantially later in the year (see “Pac rim steps up” below). 

Potential for extended profits

The following table shows the beginning percentage price changes from the low point following Brexit on July 13 to 
Nov. 25. The differences between the pound’s price changes and the changes for the other five currencies show the extent of price declines (or increased price for the pound) needed to compete with the pound. Brexit affected all other currencies along with the pound. As shown by the individual charts, the U.S. dollar was forced up when the pound’s competitors used the dollar in their efforts to decline in price.

The pound has proven to be a moving target, increasing its lead by approximately six cumulative percentage points between Brexit and Nov. 25. The toughest competitors are the euro, Canadian dollar, Swiss franc and Japanese yen. Even the best of these, the euro, was still 14 cumulative percentage points behind the pound on Nov. 25. Overall, the table above shows the potential for further gains in the U.S. dollar, more losses for several major currencies and possible positive movements by the pound.

The U.S. dollar might be described as a victim of collateral damage as a result of currency warfare, being used as an unwilling weapon in the fight. In fact, this has happened before. In 2014, the dollar – an “innocent bystander” – was forced to rise 5.56% between July 1 and Sept. 15 due to a battle for low price involving the pound, Swiss franc, and euro (see “Shadow pricing futures and ETFs”, Futures, December 2014).

Beyond its impact on currency prices, Brexit may be expected to have a noticeable negative effect on U. S. interest rates and exports. Stock market record highs during November 2016 may be due in part to the inflow of “currency warfare” capital. The dollar may not be able to protect itself, but a knowledgeable trader may thank Brexit and currency warfare for several profitable months in 2016 and 2017. 

For a review of price changes at the time of Brexit and a forecast of the currency movements shown above, see “Taking Advantage of Brexit,” December 2016, p. 56.

About the Author

Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.