Markets take a dive as U.K. votes to leave the European Union

In a referendum that essentially split the country, the United Kingdom voted to leave the European Union Thursday, a move most market experts did not believe would take place. The U.K. voted 52% to 48% to leave with a 72.2% voter turnout. Markets around the world took a nosedive following the news.

The Brexit as it is being called, has no historic precedent, and market volatility is likely to rise as the U.K. charts new waters. The Dow implied to open down more than 700 at one point, although that loss was pared after the market open, reports CNBC. Japan’s Nikkei Index was also rocked by the Brexit referendum, falling about 8%.

The market most effected by the vote, however, was Britain. The British pound sterling plummeted to a 31-year low against the dollar. It was last down more than 6% at $1.36. The dollar index, meanwhile was up 3% at one point, setting up for the biggest daily gain since 1978.

And of course, any time the dollar makes significant moves, oil follows suit. A stronger dollar means downward pressure on oil prices as the dollar-denominated commodity becomes more expensive for buyers holding other currencies. International Brent crude oil was down 4.8% at 3:55 p.m. EST today at $48.49 as markets continue to absorb the shock of the Brexit vote.

Banks appeared to take the brunt of today’s downturn, with Barclays falling as much as 30%, while Deutsche Bank tumbled 18%.

What happens next?

First – technically speaking – the referendum is not legally binding. In theory, Prime Minister David Cameron could ignore the will of a slight majority of voters, but momentum seems to be carrying the decision to reality.

Cameron announced today plans to step down in the next three months following the results of the referendum after staking his political capital on calling for the vote and winning a vote of confidence of sorts to stay in the E.U.

“The British people have made the very clear decision to take a different path and as such I think the country requires fresh leadership to take it in this direction,” he said Friday in a televised address outside his residence. “I do not think it would be right for me to be the captain that steers our country to its next destination.”

While no specific date has been determined for the current prime minister to step down, Cameron said his view was that new premier should be in place by the start of the Conservative annual conference in October. It is also his view that the next prime minister should be the one to enact Article 50 of the Lisbon Treaty, which begins the legal process for leaving the European Union.

Once Article 50 has been invoked, a series of negotiations would begin about how to disentangle the U.K. from the E.U. superstructure. The process could take two years or more, if both the U.K. and the European Council, the E.U.’s governing body, agree to extend the discussion period.

Reshaping the face of Europe

While the U.K. as a whole has voted to leave the E.U. there are calls within Northern Ireland and Scotland to seek their own political paths forward, reports Bloomberg. Scottish First Minister Nicola Sturgeon said her parliament should have the right to hold another vote “if Scotland faces the prospect of being taken out of Europe, effectively against our will.” Sinn Fein, Northern Ireland’s Deputy First Minister, called for a referendum to reunify Northern Ireland and the Republic of Ireland following the vote.

The Brexit may have serious implications for the rest of the E.U. as well. Nationalist politicians in France, Italy and The Netherlands are calling for their countries to leave the E.U., emboldened by the British.

The U.K.’s vote to leave the E.U. could prove to be a roadmap for other countries looking to follow suit. Its success or failure in removing itself from the E.U., and holding itself together in the wake of the decision, could influence movements in other European countries unsatisfied with European integration.

What does the future hold for oil prices?

The turmoil left in the wake of the Brexit decision will take months and years to shake out in Britain and across Europe. But what is the direct effect on the oil market? Will there be a major effect at all?

Oil is geopolitically secular so to speak in that oil price, demand and supply balance is indifferent to political motives and unions. The British will still drive cars, they will still use natural gas for energy, and so on. There may be trade implications with new taxation laws and some hang-ups in the flow of product across borders, but the use of oil and gas will continue mostly undeterred.

The largest change will come from the currency exchange markets after the uncertainty surrounding the decision will undoubtedly push the British pound and euro lower. This will unleash a chain of events that will likely push the price of oil lower in the near term as the influence of currency value will outweigh market fundamentals.

SDR currencies

The International Monetary Fund (IMF) currently recognizes four currencies as part of the basket that comprises the special drawing rights. The IMF explains: “The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. As of March 2016, 204.1 billion SDRs (equivalent to about $285 billion) had been created and allocated to members. SDRs can be exchanged for freely usable currencies. The value of the SDR is currently based on a basket of four major currencies: the U.S. dollar, euro, the Japanese yen, and pound sterling. The basket will be expanded to include the Chinese renminbi (RMB) as the fifth currency, effective October 1, 2016.”

Aside from the functionality of SDR and the implications to the representative value of SDR, there is an underlying effect that is worth noting. The four currencies that comprise the basket (and imminent inclusion of the Chinese renminbi) are viewed as the most prolific and consequently stable currencies in the world, and the value is dictated by a free float in the global markets.

The respective weighting for the SDR basket of the U.S. dollar, euro, Japanese yen, and pound sterling were 41.9%, 37.4%, 9.4%, and 11.3%. The euro and the British pound sterling comprise 48.7% of the SDR basket.

With uncertainty abound in the European market, the British pound and the euro have taken a beating relative to other currencies. With only four currencies in the SDR basket, there are few safe havens when two of those currencies are under fire.

Investors flock to the dollar, pushing down oil prices

The most likely safe haven for investors is the U.S. dollar, and also the Japanese Yen but to a lesser degree. The euro and the pound fall, which will consequently cause the dollar to rise. The rise in the dollar will consequently cause the price of oil to fall as an inverse relationship exists between the dollar and oil. This has been apparent in the immediate aftermath of Brexit with WTI oil price sliding by about 5%.

The prevailing question is, ‘how long will this last?’

The uncertainty surrounding the effects of Brexit spill over into the uncertainty about the oil price and the strength of various currencies. It is a possibility that investor are fleeing the euro and the pound in a swift and decisive manner, and the bulk of the action is already in the rear view mirror. Or, there are a group of investors who immediately made the move and the majority is waiting it out to see how much volatility is truly left. The middle of the road option, which may be the most likely option, is that some investors have fled and others will wait and eventually move money out if the volatility continues.

The result is that the oil price will continue to build on the losses as more investors seek safe haven in the U.S. dollar and flee the euro and pound. This will cause the price of oil to fall as the dollar strengthens and the oil price could slide as the volatility in the market finds a balance.

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