Brexit is a disaster for the EU

Outlook:

Sterling and the euro were always going to fall and Cameron was always going to resign if the Leave camp won the referendum, but aside from other forecasts of widespread ca-tastrophe, markets were not prepared for the outcome. We were not alone in putting too much weight on the bookies over the polls. Before the voting began, oddschecker.com put the odds of Brexit at only 10%. And pollsters certainly let us down, too.

The effects of Brexit will reach far, wide and deep. The most obvious side-effect is other nationalist groups seeking their own referenda, including N. Ireland and Scotland (who voted to Stay), and France and Italy. We haven't heard that Spain has a vocal Leave group but Spain is holding another election this weekend. Watch for comments.

Second, Cameron will step down, probably in October and it will be up to his successor to manage the two-year Lisbon Treaty Article 50 process of actually leaving the EU. As several European political fig-ures have said, the EU will retaliate against the UK for rejecting it, not least to punish Britain for giving ideas to their own splinter groups. It's not a stretch to compare Brexit with Grexit. For threatening to leave the eurozone, Greece has been treated very badly, even though the Greek referendum ended with a vote to stay. To be fair, some Greek politicians encouraged ill-treatment, but the Europeans were going to be harsh, anyway. Remember, to a German, debt is sinful.

Any idea that the British vote will inspire the Europeans to reform and adjust attitudes is just wishful thinking. Revenge will be the only thing on their minds. Successful retaliation against Britain may be effective in causing real harm, but demonstrations of malice can also get the backs up of those already thinking of fragmentation—it can backfire.

The Article 50 process might fall to former London mayor Boris Johnson, a loud Leave proponent who is somewhat saner and more politically savvy than Trump but has a similar image of loose cannon. Trump, of course, approved the Leave vote, but he doesn't know anything about international finance except how to snow silly bankers into giving him too-big loans. Whoever the next PM is, he will have a tough row to hoe when it comes to negotiating with the Europeans.

And weirdly, nothing much happens until the new PM formally triggers Article 50. The NYT writes that "the British government is not even bound by the result of the referendum. A report for the Constitution Society said, ‘The government could, in strict law, choose to ignore it.'" Wow. In other words, it would not be until the October election that we would know for sure that the Article 50 leaving process would be started. A candidate could run on a no-trigger platform and the UK could step back from the brink. That would infuriate the Europeans even more.

Or maybe not. Maybe this time the EU would recognize that it went too far in things like regulating bendy bananas and become conciliatory. After all, the UK is the second largest EU economy after Ger-many. Brexit is a disaster for the EU. As the NYT puts it, Brexit "raises questions about the direction, cohesion and future of a bloc built on liberal values and shared sovereignty that represents, with NATO, a vital component of Europe's postwar structure."

The EU lost Britain, the top advocate of free-market economics. We old-timers know what that means—a little pink is okay but too much pink means mobs with pitchforks and wildly unrealistic eco-nomic expectations of what government can and should do. The EU's credibility will never be the same. According to the NYT "'The main impact will be massive disorder in the E.U. system for the next two years,' said Thierry de Montbrial, founder and executive chairman of the French Institute of International Relations. ‘There will be huge political transition costs, on how to solve the British exit, and the risk of a domino effect or bank run from other countries that think of leaving.'"

Third, it remains to be seen how quickly financial markets adjust to the new situation. Brexit was a Shock because it was not expected and we were not prepared. The doom-and-gloom crowd are certain-ly right about one thing—high uncertainty inhibits capital investment. And capital investment is the core driver of economic activity. A drop in domestic and foreign incoming investment in the UK will almost certainly drive growth down, raise unemployment and discourage households from consump-tion. Inflation will not take off. Rate cuts, even to negative, and "other tools" as Carney says, may well be in the cards. As the IMF said in its June 17 report on the UK, GDP will fall from the baseline sce-nario of 1.9% to 1.1% in the worst-case.

Some companies will move their headquarters to the Continent, which has symbolic importance. We continue to think they will move back to London in the end because the UK seems to have the "special sauce" that other capitals do not, but that's down the road. The only sane alternative is New York, but the US has its own drawbacks, including (and it's not silly) the timezone.

As for the Brexit effect on the US, from the Fed's point of view, the worst-case global disruption has happened. A July hike must be off the table, although September is still a possibility, depending on US data and Brexit fallout. The NYT writes that the Brexit decision will "re-shape Britain's place in the world" and Pre Obama declared himself "heartbroken"—but the likelihood is very high that the US rushes in to bolster the "special relationship." Obama had earlier said Britain goes to the back of the queue in terms of a trade deal and other treaty and formal deals, but in practice, the US could easily rush to fill a void created by the expected absence of EU partners. After all, the US and UK are the core countries of NATO and NATO is not affected by Brexit.

And let's not forget that it is merchants who determine an economy's place in the world. It's the bank-ers who determine whether trade can be financed on letters of credit (trust) and which currency to stockpile as reserves. Thatcher said the UK is a nation of shop-keepers but extend that image from shop-keepers to merchants, and you have a dynamic, self-supporting system. France has never met its Trea-ty debt targets and Germans are really very bad at running banks. The US will miss Britain if it really goes.

The FT's John Authers says "central banks cannot take moves like this lying down." For once, it's not clear what he means. He writes "We already have a ‘Black Friday' to dwarf sterling's ‘Black Wednes-day' in 1992, when Britain was forced to leave the EU's exchange rate mechanism. That was humiliat-ing, but created the conditions for a prolonged period of growth and prosperity. The risk that this Friday will go down in history as altogether blacker is very real. The next move belongs to the central banks. Only when we have survived the short term, can we start to worry about the long term."

We agree with Krugman's comments that to imagine the UK unfettered by the EU will rise up in glory is to disregard the benefits of a customs union. We are not projecting that Britain will not suffer in many different ways, some of them unknown today, because of this choice. But there will be some ben-efits, just as de-linking sterling from a badly set exchange rate with the DM was the economically cor-rect thing to do, embarrassing or not. It will probably not be a clamp-down on immigration, as the Leave camp seeks, but rather some other growth surges in hitherto forgotten corners.

For one thing, devaluation of the pound is beneficial to exporters as long as debt and other costs are also sterling-denominated. Those who borrowed in euros or dollars might be in the soup and some fail-ures are only to be expected. That makes Job One for the BoE to manage the devaluation wisely, by which we mean without excessive volatility. Now that the big move has occurred, the BoE should seek to get the pound trading in a reasonable range without any more big moves. Does this mean the BoE will intervene, or ask G-7 to help it intervene (as it should)? Yea, probably. The form intervention takes is another matter. There's interest rate manipulation—highly likely—and outright buying and selling, somewhat less likely. This is another place where the visible assistance of the US would come in handy. Phone lines among London, Washington, New York, Frankfurt and Tokyo are no doubt already buzzing madly. Notice that Paris in not on this list.

Not to be silly, but at 8 am, S&P futures point to a drop of 3.5% at the open. Whether Black Friday is really going to have a big and lasting effect depends to some extent on how measures like the S&P 500 respond. As we have seen in other crises, like the Fukushima nuclear disaster, markets do not always freak out and go overboard. They enjoy doing it, to be sure. But because of the two-year delay even after Article 50 is triggered, assuming it is triggered, and because uncertainty is high over whether the EU will be vengeful or conciliatory, there is some likelihood that markets will just settle down fairly quickly.

Don't bet the ranch on continuing high volatility. We would really like to hear from some Europeans and Americans today. A conciliatory tone from Europe and a Lend-Lease-like initiative from the US would go a long way to tamping down the excitement. And in the end, excitement is fun for deep-pocket traders, but tends to be bad for many bottom lines. We would not be surprised to hear through the grapevine that various officials are telephoning various business leaders, including FX desk heads, to cool it.

		Current	Signal	Signal	Signal
Currency	Spot	Position	Strength	Date	Rate	Gain/Loss
USD/JPY	103.03	SHORT USD	STRONG	06/03/16	108.98	2.88%
GBP/USD	1.3885	SHORT GBP	NEW*STRONG	06/24/16	1.3885	1.95%
EUR/USD	1.1181	LONG EURO	WEAK	06/21/16	1.1340	0.62%
EUR/JPY	114.54	SHORT EURO	WEAK	05/02/16	122.33	1.28%
EUR/GBP	0.8006	LONG EURO	NEW*STRONG	06/24/16	0.8006	0.53%
USD/CHF	0.9759	SHORT USD	STRONG	06/06/16	0.9749	2.05%
USD/CAD	1.2985	SHORT USD	WEAK	06/06/16	1.2960	2.03%
NZD/USD	0.7074	LONG NZD	STRONG	06/06/16	0.6953	4.19%
AUD/USD	0.7396	LONG AUD	WEAK	06/06/16	0.7245	4.69%
AUD/JPY	76.21	SHORT AUD	STRONG	04/02/16	81.17	1.10%
USD/MXN	18.9656	LONG USD	WEAK	05/06/16	17.9418	1.71%