Brexit safe haven impacts turn global: Fed and BoJ to take note

This post discusses the increasingly global financial market “safe haven” impacts of rising Brexit uncertainties, and previews this week’s BoE, Fed and BoJ policy meetings (which will impact market tone). The main points are:

  • Previous financial market complacency about Brexit risks (see here) has been replaced by more generalised “safe haven” asset prices impacts, as Brexit odds have risen to around 44% from only 20% alongside opinion polls showing “leave” leading (both online and telephone).  And several factors could inhibit the last-minute “remain” surge witnessed in the Scottish referendum.
  • The impacts remain largest in FX space, particularly GBP implied volatilities and (negative) risk reversals rocketing to levels above those prevailing at the peak of the financial crisis (when £ERI fell 20%).  Such volatility will likely extend over the next week. Markets continue to price in significant GBP downsides over the coming months, rather than a post-referendum GBP bounce.
  • Recent GBP spot falls have been more constrained – depite a recent 3% fall the £ERI remains notably above it’s mid-April lows despite higher Brexit odds. That’s consistent with my view that the high cost of shorting GBP would help as investors seek lower-cost Brexit hedges. But GBPJPY has nevertheless fallen most, consistent with my April view. But the risks are skewed to GBP weakening further if the opinion polls/Betting market odds don’t improve as the 23 June vote approaches.
  • But non-GBP implied vols have also spiked (e.g. European FX 2-week vols up around their 2011 EA debt crisis levels, JPY vols above them), increasing the difficulty in finding “cheap” Brexit FX hedges (although commodity FX and CHF vols look potentially under-priced).
  • The global bond bull market has accelerated on Brexit uncertainties: 10-year bunds have fallen below zero, JGB yields have tested fresh negatives and bond market uncertainties have spiked. Such effects seem likely to extend near-term.
  • But Gilt yields have been nearly-perfectly correlated with Bunds, as Gilts have apparently been treated as safe havens despite the underlying shock being UK-related. This could, however, reflect the perception that a Brexit vote would trigger MPC easing (rate cuts, further UK QE) and lower inflation breakevens (which there are already signs of). The continued strong correlation between OIS rates and Brexit probabilities contradicts the MPC stance that policy could be either eased or tightened on Brexit.
  • EA peripheral yield spreads have risen,  which could start concerning the ECB.
  • Equities have retraced on Brexit uncertainties, with volatilities again spiking (albeit less than FX). But the story is of Euro Area and Japanese under-performance, particularly bank stocks, rather than large differences between with UK domestically-orientated and internationally-exposed equities.
  • The MPC will be in wait and see mode this week, with the minutes likely continuing to signal concerns about Brexit uncertainty impacts but again not wishing to add to the recent market volatility by making strong policy statements.
  • While the Fed will undoubtedly hold this week (given recent weak payrolls, falling US inflation expectations and elevated global volatility) the FOMC statement is likely to reasonably-closely mirror Yellen’s relatively-balanced 6 June speech and hence not rule out the option of a July or September rate hike (contingent on data and market developments).
  • But the risks are nevertheless skewed towards the Fed dots plot shifting to signal only one 2016 rate hike, although they may hold off significant shift dots changes given data uncertainties and the wish to avoid further pricing out of Fed rate hikes. Indeed, market pricing of only a 29% chance of a rate hike by September (45% by December) already looks overly dovish (despite my continued stress on the US Phillips curve’s flatness).
  • Renewed JPY strength and Nikkei weakness represents major challenges for the BoJ given strong import price deflation, weak wage growth and moribund CPI inflation. But the political-economy seems to have shifted against further (ineffective) rate cuts, a further QQE extension could face supply constraints, FX intervention is constrained by G20 agreements and a possible fiscal expansion is JPY-positive.
  • So the market will likely again shrug off any further Kuroda’s warnings about potential policy responses to sharp JPY moves and USDJPY could easily approach 104 (and GBPJPY around 147) as the limited expectation of BoJ action this week is disappointed. But Kuroda will likely raise the focus on the July meeting and a Brexit vote would likely provoke BoJ action.

Increasing Brexit odds add to existing global uncertainties and generate large cross-market impacts

The past fortnight has witnessed a significant shift in the EU referendum opinion polls (see here) as concerns about immigation have apparently starting outweighing the remain camp’s stress on the likely significant economic costs of Brexit (although there leave camp’s claims about post-Brexit trading relationships continue to ring hollow see here). Specifically, online bookmaker odds and direct prediction markets put the Brexit probability at 42-44%, more than double the sub-20% reported a fortnight ago when financial markets appeared complacent (see here) .  The Labour Party’s low profile in the debate has also contributed: a remain outcome relies on support from a large majority of labour voters, given that most conservative voters seem to back Brexit.

Slide2  Slide2

But it’s also notable that recently both telephone and on-line polls have put remain in the lead (see chart above), whereas previously telephone polls consistently put remain ahead.  I discussed here  how the preponderance of telephone polls seemed to have encouraged previous financial market complacency. So while most recent polls have been on-line, this apparent switch in telephone polls reduces the chances of the overall picture being biased (and reduces the importance of the on-going debate about which are more accurate, see here and here).

Obviously things could change again in the remaining week of campaigning. And the opinion polls indicate that over 10% of voters remain undecided.  But it’s unclear which side leave’s recent poll leads will benefit most. The conventional wisdom is that it will scare less-motivated wavering remain supporters into actually voting, thereby adding to previous tendencies for last-minute support increases for the status quo (which financial market participants seem to have previously been counting on).  But leave’s recent lead could equally encourage “shy leavers”. And unlike the Scottish Referendum there will be no last minute bribes available to sway voters (a considerable hardening of the line on Turkish EU membership probably wouldn’t suffice).  Moreover, Fleet Street’s pro-Brexit tendencies weren’t apparent in the Scottish referendum or the 2015 General election. So if the Labour party campaign remains ineffective there’s a definite risk that we don’t get the anticipated last-minute swing towards remain.

These elevated Brexit fears add to several inter-related global concerns: (i) weak global growth; (ii) central banks’ (in)ability to get inflation going; (iii) China’s policy options (devalue or debt buildup crash?) and general EM weakness; (iv) the Fed eventually surprising markets (see below). But it’s notable that UK Brexit-related uncertainties now exceed even Chinese policy uncertainties in the measures (see chart). Markets seem to have become more sanguine about Chinese risks, given that FX reserves have stopped falling and activity data have improved a bit. But nevertheless the yuan has continued depreciating, with the CFETS RMB basket falling to record lows.

Slide3 Slide4

This existing fragile global situation probably accounts for the apparent significant cross-market impact of the growing Brexit uncertainties, which now add safe haven effects on fixed income and equity markets to the previous FX impacts (which have also broadened away from being GBP-focussed).  As an overview, the Chart below shows how there’s been a significant rise in G10 FX volatility, a slightly smaller rise in equity volatlity and a smaller-still increase in bond market volatility.  But below I’ll also detail the significant FX spot moves, government bond yield declines and equity market weakness – which should also be weighing on Central Bankers’ minds (the Fed, BoJ and BoE this week).


FX market impacts: sterling remains the centre, especially in option-space, but safe haven appreciations generating strains 

I’ve extensively discussed the impact of Brexit uncertainties on sterling spot and implied vols/risk reversals in previous posts (see  herehere, herehere).  That close link has persisted as Brexit odds have risen over the past fortnight, although as I expected the spot GBP moves have been less pronounced than implied vols and risk reversals.

Specifically, EURGBP has risen to over 0.79 from around 0.76 a fortnight ago (see chart) while GBPUSD has fallen to 1.41 from 1.47.  But GBP remains stronger than it was in early April, when Brexit odds were a little lower: the second chart below illustrates this for the £ERI, which remains x% above it’s April low despite having fallen 3% over the past fortnight. As I anticipated here, the high cost of taking sterling short (hedging) positions seems to have curtailed even sharper GBP falls. That said, the latest CFTC data confirm that GBP short positions have recently re-extended (see Chart) and they’re not yet exceptionally stretched.


GBP weakness has been particularly apparent against JPY, both since start-2016 and over the past fortnight (see Chart below) consistent with strong safe-haven effects and my early-April view that short GBPJPY positions were particularly attractive within likely generalised GBP weakness in the run-up to the referendum.  Moreover, GBPJPY’s break below 150 could open the way for technically-driven weakness.  GBPCHF has also fallen significantly over the past fortnight, and while the EURCHF fall is relatively small thus far the SNB will neverthless be alert to potential Brexit-driven CHF strength.


Brexit uncertainties have been most apparent in FX vols and risk reversals. The first chart below illustrates that EURGBP implied volatilities have generally risen significantly, but 2-week and 1-month ones have particularly rocketed (the picture is similar for GBPUSD, where 2-week vols have risen to an unprecedented 40.1).  Indeed, short-tenor GBP vols now exceed those at the peak of the global financial crisis, when £ERI fell 20% (see my BoE article), while 2, 3, 6 and 12-month vols are only slightly below those later-2008 peaks. So option markets don’t currently price Brexit effects dissipating quickly after 23 June.  I also expect that 1-week GBP implied vols will spike sharply over the next few days, as it referendum date enters it’s “window”, alongside the whole range of GBP vols rising further (based upon the Scottish referendum experience).


The picture is similar for GBP risk reversals: there’s been a recent substantial spike in option-implied GBP downside risks. And that’s particularly apparent at the shortest tenors (again exceeding the late-2008 peaks) but also at longer tenors (only slightly below their 2009 record levels).  So, as I’ve previously discussed  option markets notably aren’t anticipating a post-referendum GBP bounce: 6-month EURGBP risk reversals are only a little less elevated than 3-month ones.

I discussed here how these exceptionally-elevated GBP vols and risk reversals raise the cost of speculating against GBP or hedging GBP-related risks, thereby causing a search for alternative Brexit hedges (ergo JPY strength).  This seems to have helped constrain sharper spot GBP moves and may continue to do so in the run-up to the vote.  That said, the bar will move higher 23 June approaches and I continue to expect a sharp 10-20% GBP fall should Brexit actually happen.

But it’s also notable that non-GBP implied volatilities have also spiked relatively sharply alongside the rise in Brexit probabilities (albeit less than GBP), thereby reducing the “cheap” Brexit hedges available. Specifically the below chart on 2-week implied vols across currencies illustrates that:
(i) GBP vols have risen above their financial crisis peak;
(ii) EUR vols have risen close to their levels during the September 2011 EA debt crisis, as markets have priced the likely negative spillovers from a Brexit on the eurozone.  This encompasses both trade and financial linkages (see chart) plus political spillovers given e.g. the 26 June Spanish general election;
(iii) vols of the other european currencies (CHF, NOK, SEK) have also rise towards their 2011 levels.  That said, CHF vol is the lowest of the three despite having the largest trade and financial exposures to Brexit and so could be underpriced;
(iii) JPY vols have risen substantially-above their 2011 levels, although it’s strong safe-haven characteristic will likely dominate should Brexit risks rise/eventuate.  Moreover, GBPJPY seems likely to fall below 150 this week on the BoJ disappointing minority expectations of action (see below);
(iv) commodity FX (CAD, AUD, NZD) vols have risen the least. While unsurprising given the likely small trade spillovers from a Brexit, commodity FX typically under-performs during periods of heightened volatility and low liquidity that could characterise a post-Brexit scenario. So there could again be under-pricing here, with investors potentially considering short commodity FX positions as 23 June approaches. But important counterbalances are provided by: (i) recent less dovish Bank of Canada and RBNZ tones, reflecting financial stability risks associated with house prices; and (ii) portfolio outflows from Europe on a Brexit vote likely ending up in the highly-rated and relatively high-yield government bond markets.


So market participants may have to look at the wider FX universe or different asset classes to hedge Brexit risks.

Bond market impacts: safe haven effects reinforce existing bull market (how low can they go?) 

The safe-haven demand generated by growing Brexit uncertainties has given fresh impetus to the established global bond market rally associated with concerns about weak global growth prospects (cf recent growth downgrades by the World Bank, IMF and OECD), QE purchases, doubts about the ability of central banks to get inflation going and reduced likelihood of Fed raising rates in 2016 (see below).

The fall in 10-year bund yields into marginally negative territory for the first time (-0.013%, down from o.32% only three month ago) and 10-year JGB yields falling to fresh record lows of -0.17% understandably grabbed the headlines (even though 10-year Swiss yields were even lower at -0.51%). And these record lows could encourage Japanese investors to raise their foreign bond holdings, putting downward pressure on the recipient markets (US Treasuries would be the obvious destination).

But less noted has been the fact that 10-year gilt yields have also fallen, reaching a record low (1.13%), despite the raging Brexit uncertainties. Indeed, in recent weeks there has been a near-perfect (0.98!) correlation between Gilt and Bund yields, up from around 0.6 at start 2016 (see second chart below). So despite the potential global shock being UK-originated, Gilts have apparently been traded as safe havens in this uncertain environment, potentially due to the gilt market’s depth and liquidity (plus their lack of shortage problems potentially impacting Bunds and JGBs).


But as I argued here this could reflect perceptions of Brexit affecting the components of nominal bond yields in offsetting ways. Specifically, Brexit seems likely to trigger MPC rate cuts and/or further UK QE as well as generate lower medium-term inflation breakevens, outweighing upward pressure on gilt yields from higher UK sovereign risk premia (cf the IFS discussion of the fiscal damage caused by Brexit).  Support for that view is provided by the continued strong correlation between 2-year OIS rates and Brexit probabilities (see Chart below), which BoE staff surprisingly have been unable to uncover (see here) and which contradicts the MPC’s stance that policy could be either eased or tightened on Brexit (although Jan Vlieghe has signalled that he could vote for further stimulus). Moreover, UK 5y5y inflation breakevens have also fallen relatively-sharply during the recent heightened Brexit uncertainty period – although the fact that the inflation swap-based measure has fallen less than the Gilt-based measure suggests that liquidity or risk premia effects may have contributed to this.


The safe haven impact of Brexit on bond markets is also evidenced by the rise in bond market volatility, although this is signifucantly smaller than the rise in FX or equity implied volatility (see chart above).  But lower-quality government bonds also haven’t shared in the bond market rally.  Specifically, EA peripheral-bund spreads have risen back to around their early-February levels (when market China concerns dominated), probably not helped by the Spanish General Election re-run on 26 June, when the EU could be potentially reeling at Brexit.  While spreads remain substantially-lower than earlier in the EA saga, nevertheless the ECB would likely prefer to see it’s QE bazooka constraining such moves.  And the small rise in EA high-yield corporate bond spreads may also be a bit uncomfortable given the recent CSPP start.


The Brexit-driven bond market developments seem unlikely to reverse in the run-up to the referendum and it’s associated uncertainties. But there are longer-term  concerns about the sustainability of the protracted bond market rally, given that: (i) the Fed could surprise markets in H2 (see below); (iii) the 10-year US Treasury yield (1.57%) is below the equity dividend yield for only the third time ever and UST yields subsequently rose sharply after the previous two occasions; (iii) the US government bond market term premia is unusually strongly negative; (iv) there are signs of Chinese producer price deflation ebbing (see chart below), although Chinese authorities have got their hands full dealing with excess capacity and high debt levels. Conversely global yields will likely continue falling should global uncertainties persist and global central banks continue having difficulty generating inflation. On the latter it’s notable that the ECB’s updated core inflation forecasts were actually revised down in May, despite the ECB’s credit easing bazooka.


Equity Market Impacts: Volatilities up but Euro area and Japan hit more than UK

Equities have also retraced on Brexit uncertainties. But the story is one of Euro Area and Japanese under-performance, particularly of their bank stocks, rather than large differences between the performance of with UK domestically-orientated firms (FTSE 250) and internationally-exposed firms (FTE 100).  But equity volatilities have also spiked, with that of the €stoxx rising a little more than S&P or FTSE volatility.  But all are less than the sharp spike in FX volatility.


Central Banks: Brexit effects encourage near-term risk-management dovishness; BoJ has the toughest gig and is more difficult to predict

This week features policy meetings by the Fed, Bank of England, Bank of Japan and Swiss National bank.  While they’re all extremely likely to be on hold, their accompanying commentary (particularly the Fed “dot plot”) will importantly impact future policy expectations and market sentiment.

Bank of England: straight bat to avoid adding to volatility

The MPC will undoubtedly be in wait and see mode this week, given the proximity of the Brexit vote. The minutes will likely continuing to signal concerns about Brexit uncertainty impacts on the real economy – they might reference the Markit PMI evidence of over a third of UK firms reporting already being adversely impacted (see Chart). But the overall theme will likely continue to be the difficulty in getting an accurate read on the state of the economy and the need to treat the recent data with a pinch of salt. But it will be interesting what they make anything of the previously-discussed recent sharp fall in UK 5y5y inflation breakevens.


But MPC will probably want to avoid adding to the recent volatility, or getting overly embroiled in last-minute political tangles, although they have a duty to report the adverse impacts of Brexit uncertainties.  So I’m not expecting any strong discussions of potential rate cuts or judgemental comments on the appropriateness of market interest rate expectations.  But it would seem sensible for MPC/Bank staff to revisit their stance that Bank Rate expectations are not being impacted by Brexit probabilities (see above and here).

Fed: on hold in June but maintaining option of July or September move, potentially lower “dots” 

The possibility of a June Fed rate hike was priced out after the very-poor May payrolls outturn (only 38k rise, taking the 3-month average down to 116K compared to 282K in December). That said, Yellen was relatively balanced on 6 June by stressing that Fed doesn’t over-interpret a single month’s figure (the data are revision-prone and volatile) and was more optimistic about the upturn in pay growth (to 2.5% y/y).  But I’ve been arguing since last summer that the flat US Phillips curve cautions against anticipating a strong inflation pick-up (see here and the Chart below).  Of course, one interpretation is that the employment slowdown reflects the US effectively approaches full-employment and that the Phillips curve is handily set to steepen. But the fall in the U3 unemployment rate to 4.7% was driven by declining labour market participation and the wider U6 unemployment rate remained unchanged at a still relatively-high 9.75 (there remains slack to be absorbed).


Moreover, Yellen also signalled on 6 June that she’s alert to potential falls in inflation expectations, both survey-based and market-implied (breakevens).  And this angle provides support for continued Fed dovishness. Specifically, the University of  Michigan 5-10 year household inflation expectations fell to a record-low of only 2.3% in June, with the press release noting that  “What makes these declines all the more remarkable is that they came in the face of rising gas prices and higher long-term inflation pressures due to (small) increases in wages.” And market US 5y5y inflation breakevens have also woryingly retraced, in a similar way to their UK equivalents (see above), although unlike their EA equivalents US breakevens remain above their previous 2016 lows.


The febrile market conditions generated by heightened Brexit risks obviously buttresses the arguments for the Fed remaining dovish. Indeed, the Fed has placed increased weight on financial market conditions and international development in recent months.  And on 6 June Yellen specifically mentioned the EU referendum as one of the concerning global risks (alongside China).  That said, the Fed risks getting into a circular situation if it stable market conditions become a as a strong precondition for hiking. After all markets had, until recently, only stabilised precisely because the Fed had become more dovish.  This endogeneity issue – markets may swoon as soon as the Fed tries to get more hawkish thereby frustrating the hawkish attempt – risks continuing until global demand moves onto a firmer footing (presuming that monetary easing is eventually effective).  But the longer this “Yellen put” dynamic plays out, the more worried the Fed will become.

The Fed “dot plot” will as usual be a key focus for market participants.  Given the above, the risks are skewed towards the Fed dots plot shifting to signal only one 2016 rate hike, especially since on 6 June Yellen omitted the previous “coming months” qualifier about the timing of rate rises.  But the Fed could hold off significant shift dots changes given market/data uncertainties (Brexit impacts could quickly dissipate after 23 June) and the wish to avoid the market further pricing out 2016 Fed rate hikes. Indeed, current market pricing of only a 29% chance of a rate hike by September (and only 45% by December) already looks overly dovish (despite my continued stress on the US Phillips curve’s flatness).

BoJ: in a difficult place, more rhetoric this month preparing for potential July action 

The recent safe-haven driven JPY strength, together with Nikkei weakness, exacerbates the already-difficult situation facing the BoJ. Specifically, USDJPY is down to around 106 (the lowest since October 2014) while EURJPY below 119 is the weakest since January 2013, and consistent with my start-March short EURJPY view.


And import price inflation clocked in at a scary -20.1% y/y in May, broadly consistent with the sharp y/y JPY appreciation (see chart above).  Moreover, Japanese wage inflation remains muted despite low unemployment (see chart below), with the Spring Shunto wage negotiations disappointing hopes for higher pay growth. So unsurprisingly Japanese CPI inflation remains stuck in a low gear, despite the BoJ’s best efforts as part of Abenomics (although in reality on the monetary arrow has been fired).  On top of these continued lowflation concerns, last the BOJ Deputy Governor warned of signs of weakness in private consumption.  So it’s unsurprisng that the BoJ has been signalling concerns about further JPY rises and it’s readiness to expand monetary stimulus if needed to hit the inflation target.


But the political-economy seems to have shifted against further (ineffective) rate cuts, while a further QQE extension could face supply constraints and impede the functioning of the JGB market. I discussed here how Japanese public opinion appeared stacked against the surprise January rate cut. And notably ruling LDP party manifesto for the 10 July elections makes no reference to monetary policy. Moreover, the BoJ will have to internalise the lesson that the surprise January rate cut didn’t have the desired impact, and indeed could have damaged their credibility.  On top of that, the usual BoJ approach is to implement a (surprise) easing and then assess it’s impact over a number of months before acting again. So further easing this week or indeed in July may simply be too soon given the proximity to the January easing.

BoJ Governor Kuroda and Finance minister Aso have, of course, repeatedly signalled that they will take action to curtail unwarranted sharp JPY appreciation.  But the snag is that their G20 commitments constrain what they can do – and the Japanese authorities were notably unable to get the the backing of other G7 members at the May summit.  That’s unsurprising given that JPY is one of the most undervalued currencies on a long-run REER basis (see here).  And that contributed to Abe again postponing the planned sales tax increase (despite the condition of there being a natural disaster not being met!). Moreover, the potential alternative of a fiscal stimulus to try and restore momentum to the economy would be JPY-supportive.

It’s difficult to call how the BoJ will try and extracts itself and the Japanese economy from this difficult situation.  A consensus seems to have building towards a July easing, probably via a QQE extension. But the above indicates that’s far from a done deal.  And this week all we may get is further rhetoric from Kuroda on potential FX intervention. But past form indicates that won’t have major impacts: the market will likely shrug and get back to being concerned about Brexit and risk aversion. Indeed, the likely disappointment of the minority expectation for BoJ action this week (by around 25% of economists) will provoke further near-term  JPY strength:  USDJPY could easily approach 104 while GBPJPY seems likely to break below 150, perhaps to as low as 147.

The BoJ will undoubtedly be hoping that Brexit-driven risk aversion quickly dissipates after the 23 June referendum thereby easing JPY strength (although Fed policy seems unlikely to generate significant USDJPY rises).  Of course, the BoJ has prior form on springing unexpected policy easings, so we can’t completely rule that out this week. But a more likely scenario could be some form of BoJ action should Brexit eventuate on 23 June.







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