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How Brexit could stress out markets this week

Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange.

Stocks and risk assets could continue getting crushed and currency volatility is expected to remain at extreme highs this week as investors weigh the fallout of the U.K. Brexit vote.

But analysts warn the market moves in stocks and bonds and other assets could also be even more exaggerated than normal, as fund managers around the world juggle positions, selling both winners and losers ahead of the end of the second quarter Thursday.

The S&P 500 tumbled 1.5 percent Monday morning to just above 2000, breaking below its 200-day moving average. European stocks were off sharply, as investors moved into bonds and gold as the potential impact on financial markets and the global economy remained unclear. Japanese stocks ended up 2.4 percent after Japanese officials signaled they may take action to control the wild move higher in the yen.

The shock of Thursday's vote by the U.K. to leave the European Union triggered Friday's selling avalanche, resulting in a record $2 trillion wipe out in global stock markets. Currency volatility was at an extreme high, with sterling the most dramatic, swinging from 1.50 to the dollar to a 30-year low of 1.32. It remained under pressure Monday, trading at one point under 1.32.

"Markets are crazy and it's going to be awhile before we can get a sense of security. The important thing is you don't have full participation. You have big volumes going through but a lot of people are going to avoid the market – asset managers, corporations… they don't need to be heroes, let the other guys pick the bottom," said Marc Chandler, chief currency strategist at Brown Brothers Harriman.

Treasury yields were lower, with the 10-year at 1.47 percent, as German 10-year bunds dig deeper into negative territory, yielding about negative 0.9 percent Monday.

"There's going to be aftershocks in the markets for the next few days, but what makes it more tricky is it's running up against quarter end and also this is the quarter end that runs into the long Fourth of July weekend. So there the willingness and the ability to warehouse risk is not going to be that high...for market makers especially," said George Goncalves, head of rates strategy at Nomura. Goncalves said the 10-year could take another run at its low below 1.40 percent.

The Brexit vote has had a direct consequence on Japan, with the yen surging Friday, reaching a level of 99 to the dollar temporarily. The yen weakened slightly Sunday evening, as Japanese Prime Minister Shinzo Abe instructed Finance Minister Taro Aso to watch the currency markets "ever more closely" and take steps if necessary. Traders have been speculating Japan would intervene to weaken its currency if it went below 100.

"Clearly you look at what happens with the yen. The yen is a safe haven currency. If the yen does not weaken, the Japanese economy is going to get destroyed," said Tony Roth, CIO of Wilmington Trust.

The S&P 500 fell to 2037 Friday, a loss of 3.6 percent on the day and now down more than 2.5 percent for the quarter to date with Monday's early losses.

"I think you're going to see managers probably try to close out positions that may already be in extreme loss positions," said Roth. "I think it could be a painful week but we should be able to form a short term bottom for sure…I don't have a specific target but I would expect (the S&P 500) to go through 2000 and head to 1900. I would be thrilled to see it hit 1900 as a long term investor with some dry powder. But I'm not thinking that would happen."

Chandler also said the markets could feel the impact of the end of the quarter as portfolio managers lock in results. "I think real money is not going to participate. We're close to the end of the quarter, the end of the month," he said.

While some economists shaved their growth expectations slightly for the U.S. in the aftermath of the vote, a number of strategists made a case for markets becoming more stable after a period of volatility, with Brexit clearly a bigger issue for the U.K.

Goldman Sachs economists Sunday cut their expectations for U.K. GDP by a cumulative 2.75 percent because of Brexit and said there's a chance the country could enter recession by early 2017.

Both Chandler and Roth said the market reaction is moving from shock to confusion.

"I think that the situation in the U.K. is going to be very confused, I would say for at least the next 30 days," said Roth. Roth said the fact there was no real time frame on the replacement for Prime Minister David Cameron added tot he confusion and market uncertainty.

On Monday, Reuters reported that Britain's Conservative committee chairman said the contest to replace Cameron should begin next week and be concluded by Sept. 2.

Chandler said the next big event for markets is the EU leaders' summit which begins Tuesday. Cameron is expected to explain the U.K.'s plans to the group, but the EU leadership is even divided about how it should be dealt with.

Chandler said the uncertainties include questions of when the U.K. will actually start the separation process with the EU, and what it means for all kinds of things from border issues to who will be the next prime minister. There's also the issue of whether there even could be another vote on whether Britain could stay.

James Paulsen, chief investment strategist at Wells Capital, said once some of the uncertainties are resolved, the sell off could be short lived and stocks could end higher on the year.

"It is interesting where we closed in the United States market (Friday). We basically had a stock market that was a little over 1 percent lower than it was a week ago Friday," said Paulsen. "We had a bond yield that was unchanged and a dollar that was up maybe a percent. My point is a lot of this is emotional consequences and this collapse had more to do with how much it went up in the four days prior."

Paulsen said the selloff could still be rough, but in several weeks from now, markets will likely be a lot more stable.