Which Banks are on the Hook for Brexit Currency Losses?

Investors are digesting the implications of the British decision to leave the European Union, as well they should.

Banks with large currency trading and hedging desks, of which there are too many to enumerate, will likely be posting outsized “one time” losses on their hedge books for the quarter ended June 30th. There is some possibility of specific bank or investment fund risk. Occasionally, traders in the forex markets go rogue, with the implicit nods from higher-ups, in efforts to bolster bank profits and pad annual bonuses. Going forward, the unravelling of sterling-Euro-USD hedges will also lead to currency losses for those on the wrong side of the bets. Forex is a large profit earner for money center banks, so much so that most banks prefer not to comment on it for fear of raising the ire of regulators and the public at large. All with experience in the hedging of currencies know full well that hedges typically fail, when a short term currency movement, becomes too severe. At that point that currency bands break, hedges need to be either unwound, or reclassified as speculative instruments and additional capital ponied up for collateral. Both scenarios represent a shock to the banking system.

With a global economy that has struggled for some years to generate reasonable GDP growth, this represents news that could ultimately lead to a European recession. Should a large money center bank reports a “Lehmanesque” shock due to massive forex losses, in the months to come, such a declaration could precipitate a financial crisis. Unanticipated external shocks typically represent the death knell of equity bull markets and are typically the harbingers for bruising bear markets. Bear markets are never orderly at the outset.

Corporations with large British divisions, or that export substantial amounts to the UK will also find that the sharp depreciation in the sterling will have an impact upon their profits.

Investors and investment markets abhor uncertainty. Some are far too sanguine about Britain’s decision to leave the EU. They point out that the UK will still be trading with the rest of the world and that all British factories will continue to make, what they presently make. The issue is not that Britain has disappeared suddenly off of the face of the earth. No, the uncertainty now sitting squarely in front of all investment portfolios, is the risk of the dissolution of the European Union, and the economic and political turmoil that would result in such an event. Britain, apparently, could not longer accept external bureaucrats mandating the requirements for asylum, the requirements that domestic budgets subsidize spendthrift member nations which refused to govern themselves according to international norms, and, anecdotally, in having the UK economy micro-managed, from Brussels, by mandarins that determine the size of eggs one is allowed to buy at supermarkets.

In the immediate aftermath of the Brexit decision, media discussion focused upon paternalism vs self-interest. Those that voted in favor of Brexit were dismissed as being uninformed, uneducated, unwashed and uncaring louts. The media might as well have used the terms knuckle-draggers or Neanderthals, such was the level of contempt. On the other side of the vote, those that voted to remain in the EU were lauded as being forward thinking progressives, infinitely more intelligent and morally superior in character. What the media, the investment community, the pundits and the politicians have failed to comprehend is that a MAJORITY of the population of Britain which voted in favor of leaving the EU cannot, mathematically, be just the great unwashed; there aren’t enough of “them” to swing the vote to such an extent. A majority of Britains, from all walks of life, all professions, all levels of education and international expertise collectively decided that enough was enough.

Going forward, it seems logical to predict wholesale defections from the EU bloc. Britain was the first domino, not the last. Originally designed as a body with a narrow mandate to improve pan-European trade; the EU steadily metastasized into a monster of a supranational government, one that holds itself as being the supreme legal and moral authority over all of the Eurozone member nations. Every remaining member nation must now assess whether or not it is willing to continue ceding national authority over borders, immigration, trade and budgets. If there were euroskeptics before, now represents their golden opportunity to get out. After all, a reasonably solvent contributor to the EU budget has decided, after more than 43 years of membership, that the model is unworkable. At stake is national sovereignty. Are remaining members willing to acquiesce their relegation to a status that is little more than a province of the state of Europe? I think not. The Euro currency has just lost any potential of retaining its reserve currency status and should be avoided until such time as a wholesale overhaul of the EU has been achieved, with the consent of all nations that choose to remain within the bloc.

For the remainder of the globe that is not Europe, the aftermath of the vote should not be considered ominous. It is, rather, a portent of the times to come. The world may be on the verge of ending a rather short (by historical standards) experiment in global “free” trade, to be replaced by trade that is unabashedly, once again, based upon national self-interest. Capitalism replaced feudalism largely due to the creation of immutable concepts regarding property rights; a central precept regarding property ownership is the right to prevent trespass. Progressives enamored with the notion of a harmonious society, based upon unfettered and full access to everyone else’s land; they ignore the merit behind the time-tested saying that “fences make for better neighbors”. More fences are likely to be erected in global elections to come.

Immigration is an important issue for all, but it is not the only irritant simmering on the geo-political burner. Altruism is also a powder-keg. For far too long, countries that were middle-class, pretending to be rich, were expected to engage in acts of largesse for the purported betterment of world good. Status preservation and peer-pressure from other nations have beggared more than a few nations. Britain decided that they wished to assert greater determination over their fiscal house. On a go-forward basis, this will leave less free money for certain spendthrift EU member states.

The Brexit will have important repercussions for individual global investment policy and allocation in the coming years. The looming question that cannot yet be answered is this: will a European recession, that looks far more likely based upon a substantial short term contraction in the UK economy; will that possibly spill over to the remainder to the rest of the world? And if so, what fiscal and monetary tools remain to bring the developed world out of the next recession? Because inflation looks to be the only remaining arrow in the quiver. inflationary tactics, which typically increase the cost of borrowing, will surely beggar indebted nations and house poor individuals that have, for far too long, lived beyond their means.