Lower for Longer
Not surprisingly, the outcome of yesterday’s referendum in the UK has hit the British pound hard and driven down the prices of equities and most commodities. Simultaneously, it has boosted the safe-haven appeal of the yen, high-grade government bonds and gold. US interest rates plunged across the curve, as bond prices rallied, with the 10-year Treasury down 34 basis points at one point to 1.4035.
Despite the knee-jerk reactions, many of the initial moves have already been partially reversed as the political rhetoric of pro-Remain policymakers has changed from that of fear to reassurance and it has dawned on investors that a long period of negotiation, rather than sudden upheaval, lies ahead for the UK and EU.
Markets have wasted no time in calling for more interest rate easing in the UK and less tightening in the US. In her testimony earlier this week, Fed Chair Yellen suggested that a BREXIT vote “could have significant repercussions” and the Fed issued a statement this morning noting that it was “carefully monitoring developments in global financial markets”. While the Fed’s longer term response to BREXIT is anyone’s guess, the Fed’s near-term response will depend on the magnitude of the fall-out in global financial markets. For guidance, we’re watching the yield spread between the UK and US 10-year treasuries closely for signs of trouble – thus far, it’s holding steady.
The UK accounts for a modest 4% of US exports, equivalent to 0.5% of US GDP. Should UK GDP fall by 5%, it would reduce US GDP by only 0.03%. More importantly, the euro-zone accounts for 15% of US exports, making it the third biggest market for US exports behind Canada and Mexico. Keep in mind however, that the BREXIT impact on the euro-zone economy will be even smaller than on the UK.
The larger, longer term risk is that BREXIT is the catayst for other EU countries to hold remain/leave referendums of their own, weakening confidence in the survival of the European experiment, and creating real, negative knock-on effects to the US economy.
- Despite the immediate negative reaction to BREXIT in global financial markets, we don’t expect the decision to affect the long-term outlook for the US economy.
- We’ll now see only one Fed interest rate hike this year, at the most, with any hopes of a near-term hike in July or September now dashed.
- We still expect that US domestic performance, in particular the prospects for a rise in inflation, will prompt the Fed to raise interest rates more rapidly than the markets expect in 2017 and 2018.