More Brexit Volatility Ahead

Major Moves

When a single issue or fundamental factor starts to dominate the market narrative, it can become a little tedious – that is probably the way many readers are feeling about Brexit. However, the seemingly never-ending "will they or won't they" of Brexit is a big problem for the market and will probably dominate the news for the rest of the week, whether we like it or not.

Traders were surprised to hear that British Prime Minister Theresa May has offered to quit following a successful Brexit, which is probably an effort to bring over more reluctant members to give her their vote. Most analysts expect that this means she will attempt another vote in parliament by this Friday on a "deal" similar to what she has brought the previous two times.

There are rumors that some Brexit hardliners and a few moderate conservatives are willing to give her their votes in return for her promise to resign, which means that another vote on Friday is likely. In the meantime, Parliament is voting on its own set of proposals that cover everything from a very soft Brexit to a Norwegian-style relationship with the European common market to a new referendum.

Parliament's votes today will not become law, but they could help establish a path toward becoming a law. If less dramatic proposals turn out to be popular, the market could see a boost in trader sentiment. Alternatively, a lack of consensus or a bias toward more rigid Brexit proposals would likely be a problem for the markets.

Based on the market's behavior today, it seems that investors are giving both Brexit votes the benefit of the doubt for now. The following chart is the exchange rate between the euro (EUR) and the British pound (GBP). I am displaying it this way to minimize the impact of the dollar and to see if investors are pricing in a bullish or bearish outcome for the GBP.

The declining exchange rate means that the GBP is gaining relative to the EUR, which indicates that investors are more optimistic about the votes. The .8650 level on the exchange rate has been a long-term pivot that is holding this week, and a break of .8470 could be used as a trigger for more bullish positions in U.K. and other Western stock markets.

S&P 500

The S&P 500 dropped again this morning but also started to recover as the news about Theresa May's resignation/Brexit deal was being reported. Do investors see this as a sign that her position is weakening despite conservative pressure? I think that is a reasonable assumption at this point.

The major index is still above its Monday lows and has been holding at its short-term pivot of 2,800, which is a good sign for bulls. Although I have been a little more cautious this week, the decline could turn into a retest or "throwback" and confirmation of the original inverse head and shoulders pattern.

I ran a search today looking for inverted head and shoulders patterns so far this year that have retested their neckline to see if there was a difference compared to those that hadn't. The data was a little mixed. If it took 11 days or less to return to the neckline, the probability of holding at that level and bouncing higher was 80%, which is good. However, if it took longer than 11 days, the probability of rising again was 60%, which is surprisingly poor for this pattern.

The S&P 500 took eight days to return to the neckline this time, which may give the pattern an edge in favor of another move to the upside. Applying statistics like this to the market is always going to be a little tricky because returns aren't normally distributed, but I would at least argue that the historical performance of this pattern isn't likely to reduce the probability of another breakout.

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Risk Indicators – Emerging Markets

From a risk perspective, volatility indexes remain moderate, and high-yield bonds are stable. These are both positives for investor sentiment. Interest rates continue to decline, which is becoming a big issue for confidence but could also stimulate a little consumer activity in the housing market if it is only a temporary issue.

However, emerging markets (EM) are more worrisome. Turkey has locked down external lending so the lira will stop dropping before the election, the South African rand continues to drop, and there is weakness in the Shanghai Composite stock index. These are all warning signs that should be monitored.

The most serious issue is the effect that EM economies can have on nearby developed markets. For example, weakness in Turkey can spread easily to one of its largest trading partners, Greece, which is a part of the EU. As you can see below, Greek stocks represented by the Global X MSCI Greece ETF (GREK) have been stable, but a break below $7.55 could be a signal that market conditions are weakening more than originally expected.

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Bottom Line – Wait for Next Week's Return to Normal

I expect this week to be dominated by Brexit news, which will keep volatility elevated. However, by Friday, I am optimistic that a clearer picture will have emerged as to whether Brexit opponents have a shot at keeping the U.K. in the EU or at least within a less disruptive relationship than a hard break. By next week, investors should have returned their attention to economic fundamentals and will be looking for the U.S. jobs report to either revert to the mean or surprise to the upside.

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