How Brexit Can Impact the Euro and the U.S. Dollar

On June 23, 2016, British voters will determine whether the United Kingdom will leave the European Union, and foreign exchange (forex) traders are collectively holding their breath. If the Leave movement succeeds, most experts predict tough times for the U.K. currency. Speculation ranges from an outright collapse of the British pound to a mild and temporary fall against the U.S. dollar and the euro.

Why Brexit Could Harm the Pound

The British exit, or Brexit, introduces a lot of uncertainty in financial and investment markets. Because forex markets are naturally focused on the short term, new instability usually precedes a sell-off. Nervous forex traders are likely to dump the pound, move to more stable currencies and wait until the newly independent United Kingdom proves it can be stable.

Another reason for the pound's likely struggle after Brexit is the United Kingdom's large outstanding debt. By the time the referendum vote takes place, the U.K. national debt will reach past 1.72 trillion pounds. This represents approximately 90% of the country's gross domestic product (GDP). If leaving the EU triggers a recession, as the International Monetary Fund (IMF) and British Treasury have predicted, the British government may struggle to meet its debt obligations.

If the Bank of England (BoE) responds to debt problems or an economic slump with expansionary monetary policy, expectations of future British inflation should rise. This makes the pound less attractive in forex trades. To make matters worse, Standard & Poor's already issued a warning that Britain risks jeopardizing its AAA rating if Leave carries the vote.

The U.S. Dollar as a Safe Haven

Ever since the Bretton Woods conference, the U.S. dollar has been the de facto reserve currency for the world. Backed by the full faith and credit of the U.S. federal government and strengthened by the impressive productivity of American workers, the U.S. dollar has historically been a safe haven for currency traders.

Adding to the dollar's attractiveness is the relatively hawkish policy from the U.S. Federal Reserve. The European Central Bank (ECB) and Bank of Japan (BOJ) both started negative interest rate policies (NIRP) in 2016. Even though the Fed remains in extremely low territory and expectations of future rate hikes have diminished, its policy is still less inflationary than rival central banks.

Uncertainty With the Euro

There is also potential for a euro flight if the United Kingdom pulls out. Losing the United Kingdom threatens the political and economic stability of the entire EU, which already suffers from internal conflict and banking issues. The clear winner from ongoing drama in the continent would be the U.S. dollar.

Nevertheless, most experts still predict a Brexit to hurt the pound more than the dollar. Even if the euro weakens against the dollar, it might see gains against the pound. Volatility on both ends could decouple the euro from real economic data, creating overvaluation or undervaluation and setting up forex markets for a bumpy ride.

An Alternative Argument

Even if the United Kingdom leaves the EU, it is not certain that the pound will sink. Forex markets have been bracing for the Brexit over several months. Many brokers raised their margin requirements, and the GBP/USD pair already created profit opportunities during prior sessions. There are similar characteristics in the GBP/EUR pair.

There is also the possibility of the U.K. government announcing pro-growth, pro-trade and other currency-friendly measures in the event of a Leave vote. It is difficult to predict such events, and it might be unlikely if the government in London receives pushback from Scotland or Northern Ireland on divergent policy. Still, there may be opportunity for stabilizing rhetoric or activity from Parliament or the Cameron administration.

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