The curious market reaction to Brexit

Written by Mike Riddell
29 June 2016

Headlines over the past few days have screamed about record falls in sterling, record low bond yields and massive falls in equity prices.

However, if you take a slightly longer view of markets rather than simply the one- or two-day reaction, I think it’s amazing how little markets have reacted to the Brexit vote.

Take sterling. Yes, the moves on Friday and to a lesser extent again on Monday were clearly large. Deutsche Bank’s Jim Reid pointed out that Friday’s 7.6 per cent drop versus the US dollar was the 9th biggest since 1862 – not actually the biggest ever, but still huge.

Let’s put this sterling ‘slump’ in context. The chart below demonstrates the moves in currencies since 14 June up to 7pm yesterday. 14 June was the low point in GBP/USD in the weeks leading up to the referendum (but still only the lowest since April), and was around the time when the bookmakers briefly increased the odds of a Brexit vote to as high as 40%. If you had told people on 14 June that Brexit would actually happen, I doubt anybody would have expected that sterling would only fall by 5.6 per cent versus the US dollar from that point to two weeks later, or by just over 4 per cent versus the euro. The UK’s real effective exchange rate, which is its trade-weighted exchange rate adjusted for inflation, is now only back to where it was exactly three years ago.

Click here for chart

Source: Bloomberg as at 28/06/2016. Please note, past performance is not a reliable indicator of future results.

Yes, we know that government bond yields tumbled to a record low post-Brexit, and 10-year gilt yields hit 0.93 per cent at the end of Monday, the lowest ever. The 29 basis point drop in 10-year gilt yields on Friday was the second biggest daily drop of the last 20 years. But 10-year gilt yields at 0.96 per cent as at yesterday’s close are only 18 basis points below 14 June – admittedly a notable move in a normal market environment, although less than the 23 basis point rally we had already seen in the first two weeks of June. The drop in gilt yields from 14 June to yesterday doesn’t even rank in the top 600 of the biggest (rolling) two-week falls in 10-year gilt yields in the past 30 years (13th percentile overall).

If on 14 June you had been told the UK would vote Leave, and were asked to guess the best-performing developed country 10-year government bonds, you wouldn’t have guessed Spain (-25 basis points). And you probably wouldn’t have guessed that Brazilian and Colombian US dollar debt would do even better. You’d likely be shocked that the FTSE 100 would be 3.7 per cent higher! (OK, the FTSE Mid 250 was down 4.5 per cent, but still…). You’d probably be less surprised that Eurozone bank equity prices fell 9.2 per cent (Euro Stoxx Banks Index), although this is less than a third of the move that had already happened in the year up to 14 June. That said, UK bank equities only fell 3.8 per cent in the 10 days from 14 June (FTSE 350 banks).

It seems that either:

  • markets are being massively complacent and there are big falls still to come, or
  • markets seem to think there is a reasonable chance that the UK won’t leave despite the vote (if so, I disagree), or
  • markets seem to think any EU exit will be smooth and the UK will basically get the same terms as when a member (if so, I strongly disagree), or
  • markets had already priced in a great deal of Brexit risk 10 days before the result was announced, or
  • markets know it’s a big deal, but are waiting for global central banks to fly to the rescue and make it all fine again, or
  • Brexit actually doesn’t matter that much.

The answer probably varies by asset class, and even by instrument. The biggest risk premium that had been built in ahead of the vote was clearly sterling, where markets were essentially pricing in Armageddon, as shown by one-month option implied volatility between sterling and the US dollar as high on 14 June as at the worst of the financial crisis in October 2008, a time when the UK banking system was on the brink of collapse.

It’s likely that government bonds were already pricing in a reasonable chance of Brexit, given that the sharp rally that began globally but particularly in gilts at the beginning of June seemed to broadly coincide with the bounce in Brexit in the polls, and the odds of a leave vote with the bookmakers. The government bond sell-off from 14 June to 23 June coincided with a swing back to Remain.

Corporate bonds and peripheral government bonds didn’t seem to be pricing much risk in before the vote, and the periphery in particular doesn’t now appear to be pricing in much risk of things going wrong after the vote, so spread products seem to be waiting for more monetary loosening (loosening that is already technically happening, with 1ECB’s 2TLTRO2 kicking in on 24 June).

The toughest question to answer is whether Brexit actually matters for markets or the economy, because nobody knows, and we won’t get much of an indication for the UK economy until PMIs for July are released in early August. In the meantime, there are many market indicators of contagion spreading around the world, but European bank equity is probably the one I’d watch most closely.

¹ECB: European Central Bank. ²TLTRO: targeted longer-term refinancing operations. This is not a recommendation or solicitation to buy or sell any particular security. Source: Alllianz Global Investors, 29/06/2016

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