To Hedge For Brexit, Sell EUR/USD Not GBP/USD

Following the Brussels bombing, the pound weakened alongside the euro. This was due to the growing fear of a “Brexit”. Nevertheless, a Brexit could also hurt the euro. Here is the explanation from Bank of America Merrill Lynch:

Here is their view, courtesy of eFXnews:

We argue that the EUR is underpricing the potential economic disruption related to Brexit and shorting EUR/USD is a cheaper way than shorting GBP/USD to hedge for such a possibility.

If the UK does exit the EU, we think it is unlikely to only affect the UK, it will likely also affect the Eurozone through both direct and indirect channels.

The vol spread between GBP/USD and EUR/USD is at historically high levels. However, our analysis suggests EUR could also weaken if the market becomes more concerned about the possible implications of Brexit ahead of the referendum and potentially weaken more if the UK does exit the EU.

In our view, the currently high level of EUR/USD makes shorting the cross even more attractive to hedge for a Brexit scenario. We have argued the market has not fully appreciated the implications of the ECB’s aggressive policy easing last March. We expect the Fed to hike twice this year, compared to market expectations for one hike, as US data continue improving and inflation is picking up. The Eurozone data have been losing momentum, while the US data have been gaining momentum, supporting a weaker EUR/USD (Chart 9 and Chart 10). Inflation expectations have been falling in the Eurozone, while they increased in the US recently (Chart 11). We expect EUR/USD to reach parity by the end of the year and would view the currently high level as a good one to sell ahead of the EU referendum.

Shorting the Euro may be preferable from shorting GBP to position for Brexit risks also because of what may happen if the UK does stay in the EU. In such a scenario, which is our baseline, we would expect GBP to appreciate sharply as uncertainty dissipates. However, we would not expect the Euro to appreciate by much, as it is not pricing the same level of uncertainty currently.