Margaret Thatcher’s 1979 election victory speech famously quoted St Francis of Assisi: “Where there is discord may we bring harmony, where there is error may we bring truth, where there is doubt may we bring faith, and where there is despair may we bring hope.” The decision to hold a UK EU membership referendum has proved the antithesis of such aspirations. The irony is that Thatcher was a key proponent of the EU expansion to Easter Europe which has ended up causing such immigration angst. But the shock of Thursday’s Brexit will resonate across global markets, economies and politics in the months ahead. So it’s frustrating that the Brexiteers don’t have a precise plan and many “leave” supporters would likely be unhappy with the Norway-style UK deal mooted by several Brexiteers.
My prediction that all hell would break loose in financial markets on underpriced risks of a Brexit vote has proved accurate. Sterling has plummeted, bank equity prices have tumbled sharply (imposing UK taxpayer losses far exceeding the cost of UK EU membership), “safe haven” bond yields have hit historic lows (including Gilts thus far) as have inflation breakevens but EA peripheral spreads have risen. Despite £’s record 1-day fall and £/$ reaching 31-year lows, £ weakness has room to extend further as: (i) the market digests the economic costs of Brexit, especially if a Norway-type deal isn’t agreed; (ii) MPC rate cuts and QE extension are increasingly priced; (iii) market risk aversion will likely remain persistently high – the economic and political uncertainty likely won’t resolved quickly – which could see the risks associated with the UK’s 7% of GDP current account deficit crystalise; (iv) rumours of hedge funds preparing to turn more negative on £ proving accurate.
So £/$ could easily fall into the mid-1.20’s, despite the Fed holding off on rate rises, while £/¥ will remain especially sensitive to risk aversion (concerted FX intervention thus far shows no signs of materialising). While €/£ also seems likely to rise further, with 0.85, easily achievable but more substantial upside constrained by Brexit’s adverse spillovers onto the Eurozone economy and consequent potential fresh ECB easing (although their toolkit appears more stretched). Thus far £’s fluctuations have continued to be closely correlated with OIS rates, suggesting that FX risk premia haven’t been important. But that contrasts with the experience during the 2008/9 financial crisis when the £ERI fell less sharply but cumulatively more (24% versus the 15% post-November fall). So a shift can’t be ruled out, although the UK banking system’s better capital/funding position is an important difference.
The main near-term hope for financial market stabilisation, especially of global equity prices, is the potential growing expectations of global monetary/fiscal policy responses. But that would give further impetus to the global bond market rally: high-quality government bond yields have further room to fall near-term. Or there could be near-term limited short-covering corrections on perceptions of overreaction (until the bad economic news starts arriving). Indeed, complete chaos has thus far been averted by BoE Governor Carney’s soothing words, the BoE’s liquidity facilities and the BoE’s diligent work with UK banks to raise capital buffers, reducing funding vulnerabilities and stress test for adverse scenarios. The BoE is one of the few players to emerge with any credit.
But MPC seems very likely to cut interest rates to around 0.1% and re-start QE (£50bn) alongside the publication of the August Inflation Report, and an initial 25bp rate cut is possible at the 14 July MPC meeting (at a minimum several rate cut votes seem likely). The unbalanced UK economy was already slowing ahead of the referendum (see here) and protracted elevated economic/political uncertainty will hit consumption, hiring and fixed investment. The dominant service sector is exposed to a poor post-Brexit deal, including financial services firms relocating if EU passporting rights aren’t maintained. So the service sector trade surplus is vulnerable and in any case 2008/9 experience cautions against hoping for a significant net trade boost from sterling’s depreciation. Despite their previous ambiguity, MPC will look through the likely temporary inflationary pressure from sterling’s depreciation (given persistent below-target inflation) and ease in response to the wider output gap as the UK suffers a moderate recession from H2. The severity of the downturn will depend on whether UK households and firms believe Carney and Osborne’s positive words, plus the precise post-Brexit deal eventually agreed. Together with lack of timely data on Brexit’s impacts, this means that MPC faces considerable uncertainties in choosing appropriate policy response. But they will likely follow a “risk-management” approach and ease policy as insurance against particularly adverse outcomes and to support confidence.
The key priority of the remaining 27 EU members will be to avoid others’ temptation to follow the UK through the exit. So their negotiating stance will likely be firm, but hopefully constructive. But the ECB will also be concerned about the likely adverse economic spillovers from Brexit alongside the sharp drop in Eurozone bank equity prices (blunting their credit easing Bazooka), 5y5y inflation breakevens hitting record lows and higher peripheral-bund spreads edging higher. At the same time, the previous tentative signs of improving EA growth momentum risk disappearing. So further ECB action seems possible, even if their toolkit appears increasingly stretched, the efficacy of the marginal measure is falling and ECB hawks have been stressing the need to return to normal policy as soon as possible. A tweak to the parameters of the ECB easing programs seems most likely. But the much-needed structural reforms which the ECB has been increasingly encouraging (see Draghi’s speech) may get derailed by increased populism and approaching elections.
A 2016 Fed rate hike now also looks unlikely after the Brexit vote, adding to my existing concerns about the flat US Phillips curve (see here). While markets pricing of a 20% chance of a Fed rate cut risks being overly dovish, ex post their views have proved far more accurate than the Fed’s dots. And the Fed seems to have been edging towards recognising the “new normal” e.g. Bullard’s provocative speech.
Overall, the Brexit vote marks an important rebellion against the globalisation and free trade trend of recent decades. And there’s a risk of populism gaining momentum in other countries. While Sunday’s Spanish election result provides some reason for optimism, the right-wing parties advocating French and Dutch EU referendums look in relatively-strong positions ahead of 2017 elections. And the apparently strong impact of the media on the UK result (“it was the Sun wot won it”) cautions against writing off a Trump presidential election win (which would be $-negative).
UK politics predictably up in the air, risks amplifying bad economics
The after-shocks of the Brexit vote have reverberated in the UK political system. My May warning that a Brexit vote would just be the start of UK political uncertainties has proved an under-estimate. While I expected David Cameron’s resignation, over half of the labour shadow cabinet quitting was more surprising (even if Jeremy Corbyn’s luke-warm pro-EU campaign was one of the reasons I worried about a Brexit vote) and the SNP have quickly militated for a second Scottish independence referendum. The Brexiteers lack of a precise post-Brexit plan and the delay in selecting a new Prime Minister unnecessarily prolong the uncertainty. Neither financial markets nor UK households and firms will appreciate this parlous state of affairs.
Leading Conservatives’ apparent backing of a Norway-style (EEA) deal to maintain single market access (hopefully including financial services passporting rights, see below) would reduce Brexit’s economic costs. But many “leave” voter would be disappointed with this, given that it entails continued free movement of labour and contributions to the EU budget. UKIP could consequently likely see a surge in any fresh General election, probably at Labour’s cost.
UK political stability has previously been a major attraction for international investors, so prolonged political uncertainty could magnify financial market movements in the months ahead. The Eurozone crisis indicates that financial markets price political risks, although the next section indicates that this hasn’t yet been important for £. The underlying tragedy is that this could have been avoided if politicians had been more honest about the real-world constraints, rather than resorting to “project fear” accusations against at any expert trying to introduce some facts to the debate.
Financial market reaction: sharp FX, equity and bond market moves but global panic ameliorated by BoE words
As summarised above, the post-Brexit financial market moves have been predictably large. Sterling’s record-busting 10% fall in the hours after the Brexit result became apparent (see chart) has hogged the headlines, exceeding anything observed even during the 2008/9 global financial crisis or after GBP’s 1992 ERM exit. And GBP weakness has continued this week, probably as markets have had a weekend to think about the full ramifications of the Brexit shock. GBP has, as I expected, been weakest against JPY (safe haven effects combined with perception that the BoJ is backed into a difficult corner). Specifically, GBPJPY is down a startling 15% over the past two days, taking the cumulative fall to 28.6% since mid-November, nearly double the 15.2% GBP TWI depreciation over that period.
The two charts below stress just how unusual the 9.2% GBP TWI fall in the past two trading days is: it’s not far away from the 11-13% falls which occurred twice during the 2008/9 financial crisis. But the later occurred over the course of a month, rather than two days. But it’s nevertheless also notable that the cumulative 15.2% GBP TWI fall since mid-November remains substantially-smaller than 2008/9’s 24% peak to trough fall. An important reason is that EURGBP’s moves have been constrained a little by the adverse spillover effects of Brexit on the Eurozone.
But it’s also notable GBP has continued closely tracking UK OIS rates (i.e. MPC rate expectations), even for the unprecedented GBP fall over the past two days, as MPC rate cut expectations have been ramped up (see Chart, the link remains a little stronger than for UK-foreign swap rate differentials, I discussed how it was strange that Bank staff hadn’t been able to ). So there doesn’t seem to have been any major FX risk premia yet being at work: it’s all about the perceived economic hit to the UK economy and consequent likely MPC easing (which seem underpriced, see below, supporting prospective further GBP weakness). And that picture contrasts with the pattern during the 2008/9 global financial crisis: while the trend decline in UK OIS rates broadly matches GBP’s 2008/9 decline they failed to capture GBP’s higher-frequency ebb and flow (as did UK-foreign swap rate differentials). This probably reflects the better capital/funding situation of the UK financial sector: my BoE article detailed how measures of UK banking sector stresses helped account for GBP’s 2008/9 fluctuations.
As discussed above, several factors point to further GBP weakness in the coming weeks and months while the post-Brexit negotiations proceed: (i) the market digests the economic costs of Brexit, especially if a Norway-type deal isn’t agreed; (ii) MPC rate cuts and QE extension are increasingly priced; (iii) market risk aversion will likely remain persistently high – the economic and political uncertainty likely won’t resolved quickly – which could see the risks associated with the UK’s 7% of GDP current account deficit crystalise; (iv) rumours of hedge funds preparing to turn more negative on £ proving accurate. So GBPUSD could easily fall into the mid-1.20’s, despite the Fed holding off on rate rises, GBPJPY will remain especially sensitive to risk aversion and EURGBP could rise to around 0.85, although upside is constrained by the adverse impact of Brexit on the EA and consequent potential further ECB action.
The second major “risk off” post-vote market development has been the pounding taken by UK bank equity prices have taken a pounding over the past couple of days. In particular, Barclays and RBS share prices have fallen around 31% while LLoyds is only slightly behind. Such falls are similar to those during the 2008/9 financial crisis (see second chart), although the cumulative fall has thus far been far smaller. The large impact of the Brexit vote on UK bank shares seems to reflect a combination of factors: (i) UK banks’ exposure to lower property prices; (ii) reduced lending business in a slowing UK economy; and (iii) lower in interest rate margins with the likely MPC rate cut; (iv) bank equities’ general pro-risk nature. But it’s also been notable that the more domestically-focused FTSE 250 index has substantially under-performed the internationally-focused FTSE 100 (-13.3% versus -5.4% moves over the past two days). So there’s some UK-specific concerns being voiced, consistent with the GBP depreciation.
But it’s notable that Eurozone bank equity prices have also been pummelled after the Brexit vote, signalling significant adverse economic spillover effects plus perhaps perceptions that consequent further ECB easing could . While the biggest falls have been witnessed in Italian, Irish, Greek and French banks (not that much different from UK bank’s falls) even German bank equity prices are down around 20% in the past two days.
The other big “safe haven” trade has been sharp falls in government bond yields. The 40bp fall in 10 year gilt yields over the past two days is fairly unprecedented and has taken yields below 1% for the first time. Indeed, the latest fall in gilt yields was the sharpest in the G10, with the fall since mid-November being marginally the second-largest. So thus far there’s no signs of gilts losing their safe haven status, depite impending ratings agency downgrades, which are almost-universally ignored by G10 bond market traders. Indeed, while UK sovereign CDS premia have risen to three-year highs, they remain far lower than during the peak of the financial crisis and Gilt-OIS spreads have continued their recent declines (see Chart).
But the big picture is one of the global government bond rally accelerating after the Brexit vote shock. Yields on 10 year bunds and Swiss goverment bonds have also reached fresh record negative levels after the Brexit vote, while JGB yields remain within a whisker of their record negatives. With fresh MPC easing (QE) likely and possible from the ECB (with much of the recent bazooka yet to be fired) there’s little near-term prospect of yields rising. Rather the risks are skewed to further falls in G10 government bond yields. That said, some longer-term factors indicate that government bonds are becoming overpriced (see here) but risk aversion will need to retrace for those longer-term attractors to kick in which seems unlikely near term.
Prospective UK macro slowdown to lead to MPC policy response
The Brexit shock is hitting the UK and global economy at an inauspicious time. As I discussed in April, UK growth has already slowed and remains unbalanced. And it continues to be reliant on consumption, with the savings rate worryingly at multi-decade lows, while both fixed investment and net exports show few signs of supporting growth (see Chart). The record 7% of GDP UK current account deficit also represents an ongoing vulnerability: although it reflects weaker FDI income (lower returns on UK foreign FDI assets) it’s funding account has become more reliant on more volatile portfolio inflows.
Brexit’s near-term adverse macro impacts will primarily arise via uncertainty-related effects: consumption (especially of durable goods), hiring and fixed investment will likely all be hit as household and corporate confidence declines alongside the heightened economic and political instability (see here on the spike in the UK policyuncertainty.com measure). So it’s inauspicious that consumer confidence had already weakened, particularly general economy concerns and major purchase intentions while saving intentions have risen (see Chart above). Similarly, UK PMI have declined, with over a third of firms reporting Brexit-driven hits (see here). Moreover, a flash IoD survey of the impact of Brexit makes worrying reading: 64% think that Brexit is negative for their business (37% very negative); 24% are planning to freeze recruitment with 5% making redundancies; 36% are planning to cut investment (19% significantly) and 22% are considering moving some of their operations outside of the UK.
Weaker investment intentions are also apparent in the BoE agents survey (see Chart below), alongside weaker employment expectations. And services employment intentions fell to a 33 month low in the May PMI. So the latest better than expected ONS labour market data (unemployment falling to 5.0%, regular pay growth up to 2.3%) seem unlikely to extend further in the highly-uncertain post-Brexit world.
While MPC have argued that after a Brexit vote they face a “trade-off between stabilizing inflation on the one hand and output and employment on the other” and that the policy response “will depend on the relative magnitudes of the demand, supply and exchange rate effects” markets haven’t bought that story, with OIS rates being very correlated with betting market Brexit odds (see here). So it’s unsurprising that the OIS-implied probability of a 2016 MPC rate cut have jumped to 80%, up from 30% just before the referendum (see here), but with “only” a 67% chance of rate cut by August. To me that seems to under-price the chance of MPC action. While their “could either cut or raise” characterisation is theoretically correct – it also recalls my BoE work arguing that MPC response to GBP moves should depend on why they’ve occurred – the inflation upside from the GBP’s recent fall will be temporary and should be welcomed given recent persistently inflation undershoots (even core CPI hasn’t been at target since Q3 2013). So they’ll likely put more weight on the widening output gap generated by the previously-discussed uncertainty-driven demand hit (supply moves more slowly) which will have more persistent deflationary impacts. Indeed, Carney’s comment on Friday that “In the future we will not hesitate to take any additional measures” suggests a change of stance.
MPC face the problem that hard evidence on the real-economy Brexit impacts won’t be available for a number of months, with for surveys. Plus they won’t know the details of the proposed post-Brexit settlement until October at the earliest. But MPC neverthless shouldn’t sit on their hands: there’s a strong risk-management argument for a precautionary easing (relative costs of different policy mistakes) and prompt, but not panicky, easing will support confidence. So an initial 25bp rate cut at the 14 July MPC meeting is completely possible, with at least MPC members Vlieghe and Haldane likely to vote for it (or more). But further easing, including potentially taking Bank rate close to zero (0.1%) and a likely £50bn expansion of the QE programme will probably have to wait for the August IR. That will give MPC and Bank staff time to run some scenarios through their models and have a clearer picture on the size/persistence of the financial market impact (e.g. whether a larger sterling crisis is developing, although that seems unlikely). Such a two-step easing approach has strong signalling benefits. While coordinated FX intervention also can’t be ruled out if GBP goes into freefall (and the JPY rise accelerates substantially) that’s not my central scenario.
International policy impacts: ECB concerns growing, 2016 Fed rate hike unlikely
The ECB will also be perturbed at by several post-Brexit financial market developments.
First, the previously-discussed sharp falls in Eurozone bank equity prices: over the past two days they’ve fallen by similar amounts to UK banks in Italy, France, Ireland and Greece but also down around 20% in Germany and Spain. Moreover, EZ bank equities have significantly underperformed since start-2016 (as has the overall €stoxx index, albeit at a higher level). Of course, ECB concern about EZ bank weakness, with high non-performing loans in countries like Italy, has prompted ECB action including their credit easing bazooka (TLTRO 2, CSPP on top of QE extension see here). So the concern is that the Brexit shock could derail/limit the impact of that stimulus.
Second, the Eurozone 5y5y inflation breakevens plunging to a record-low of only 1.25%, down 17bp in only two days and pushing through their previous late-February low. The ECB will likely be hoping that this reflects stressed market trading conditions rather than a further erosion of the inflation credibility. But it’s notable that UK inflation breakevens didn’t plunge, despite the underlying shock being UK-orientated (but with substantial adverse spillovers on the EZ’s fragile recovery).
Third, while core bond yield have set fresh record lows (10-year bund yields at -0.11%) peripheral-bund spreads have been edging back up (see Chart). That said, spreads remain far below their earlier levels and this time around it’s more a story of peripheral yields falling less than bund yields, rather than peripheral yields rising sharply. Moreover, Podemos’ failure to make inroads in Sunday’s Spanish general election re-run is an optimistic sign, also Rajoy’s PP also fell short of obtaining a majority.
But the concern for the ECB is that these developments come These developments come alongside signs that the tentative improving in EA growth momentum is fading. For example, the PMI data were disappointing (see Chart).