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posted on 25 June 2016

Brexit: Why So Scary?

by Pebblewriter,

Listening to various government officials and billionaires talk about the Brexit, I'm reminded of the Barry McGuire Vietnam War classic Eve of Destruction (how many other songs can work the word "coagulating" into the lyrics?)

Would a Brexit really bring the house of cards tumbling down? And, why are TPTB (the powers that be) so apoplectic about it? And, finally, what can we expect from key currency pairs and equity indices?

Instead of focusing on the intraday squiggles in the markets, today I'd like to take a step back and evaluate the big picture in light of what the Brexit might really mean.

First, let me assure you that I have no horse in this race. Though, given the steady stream of lies and misinformation from government sources over the years, I'm naturally hesitant to believe most of what they say.

The City of London is one of two critical financial centers of the world (the other obviously being NY) and would not disappear if the UK were to leave the EU. It would continue as before, though with less interference from Brussels.

Likewise, I believe trade would be largely unaffected. There would be winners and losers, but trade is usually a mutually beneficial exercise - or, it doesn't happen at all. Were one party to try to press unfair advantage, the other would have plenty of ammunition with which to level things out.

Why TPTB Are Freaking Out

The biggest potential risk, I believe, is in the derivatives markets. In the wake of the Great Financial Crisis, central bankers have spun an elaborate web of interlocking relationships between currencies, interest rates, debt and risk.

Rather than reduce the $1.5 quadrillion (imagine a stack of $100 bills over 1 million miles high) in derivatives exposure that nearly destroyed the financial world, they have tried to massage it into meaninglessness by permitting participants to engage in fairy tale accounting. has some great visuals on the amount of money involved.

This one shows $1 trillion, so you'd have to multiply the number of $1 trillion towers by 1,500, but you probably get the idea.

If I write a contract limiting your interest rate and currency exposure on a $500 million euro debt facility, I'm on the hook should things move against me. If I sell pieces of the this contract to 50 different banks and insurance companies, they're technically on the hook, too.

Yet, I'm allowed to say that I have no exposure simply by pointing out that I have other positions that offset my risk. This is called netting. And, it completely ignores the risk that my other positions might not fully offset the risk, as well as the risk that any number of the participants in the daisy chain of obligations might go belly up as did Lehman, Bear Stears and AIG a few years back.

Many other banks and investment banks would have followed them into oblivion had not TPTB decided to let them utilize fairy tale accounting. The government officials, bankers and billionaires arguing that the Brexit could be disastrous for global finance know all about the risk. In fact, they're deeply familiar with them.

This past November, I updated the biggest banks' Wipeout Ratios. As the table below shows, a mere 0.25% decline in the value of their derivative portfolios would wipe out the Tier 1 Capital of JPM, C, GS and BAC. Is it possible that a 0.25% decline might occur in the wake of a Brexit?

The Bureau of International Settlements sure seems to think so - unless you believe the timing of the all hands on deck meeting scheduled for Jul 23-28 in Basel is a coincidence.

Let's take a look at some of the key currencies and indices that might be affected by a potential Brexit, and why TPTB cannot permit the referendum results to stand.

The first currency that comes to mind, of course, is the British pound. In euro terms, the EURGBP, it has followed some fairly well-formed patterns.

Note that the EURGBP represents the amount of pounds sterling it takes to buy one euro. So, as the value increases, it represents an increase in the amount of pounds it takes, a relative weakness in GBP. As the value decreases, it represents a relative strength in GBP.

In general, EURGBP has maintained an inverse relationship to the S&P 500 - meaning that EURGBP strength (GBP weakness) has been negative for stocks, and vice versa. To put it another way, a strong GBP is good for stocks, and a weak GBP (rising EURGBP) is bad for stocks.

The rising white channel, in general, represents a gradual decrease in the value of the GBP relative to the euro, while the falling purple channel represents a gradual increase in its value.

The chart above shows six distinct periods of valuation shifts.

(1) From the advent of the euro until May 2000, the GBP strengthened relative to the EUR. Note that SPX topped out two months prior in Mar 2000.

(2) For the most part, the EURGBP recovered while stocks plummeted.

(3) While SPX climbed from its 2002 lows to its 2007 highs, EURGBP went mostly sideways.

(4) As stocks plunged again, EURGBP spiked higher, topping out 3 months before SPX bottomed in Mar 2009.

(5) As SPX recovered from its 2009 lows, EURGBP began a slow, steady decline to the bottom of the white channel.

(6) EURGBP began a sharp rise again in Jul 2015, rebounding about 1/3 of the way back to the top of the channel. EURGBP bottomed out on Jul 17, 2015, when SPX closed at 2126 - just 8 points shy of its new all-time high set on May 20, 2015. Over the next five weeks, while EURGBP bounced off the channel bottom, SPX shed 12.2%.

What Does it All Mean?

By now, two conclusions should be patently obvious. First, a sudden devaluation in the GBP could do a great deal of damage to stocks. We can argue sovereignty and national pride all day long, but this is the relationship that has TPTB's knickers in a bunch. It's also why you'll find few cabbies or maids warning about the dangers of a Brexit.

Editor's note: An extended version of this is article was posted for subscribers at

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