June 24, 2016

‘Brexit’ Has Happened!

Yesterday the United Kingdom voted, roughly 52% to 48%, in favor of leaving the European Union. Even as the votes were still being counted yesterday, markets were already in motion and reacting to the news. Equity futures were down over 5% at one point (now only 2.5%), and the 10-year treasury yield reached as low as 1.40%. Currently it is trading around 1.56%, but with significant volatility today.

Another side effect of the volatility in the market today is that bid prices will likely be poor, as liquidity has weakened. While dealers wait to see where the market is going to settle in, bid prices on bonds will be both low and sparse. On the reverse side, we are already seeing many dealers pull a portion of their offerings and waiting to re-offer those bonds once the market calms down.

Stocks in London were down, but not as much as stocks in the rest of Europe. Along the same lines, the UK 10-year Gilt dropped 32 bps, while the German Bund only dropped 20 bps. All of this suggests that the markets are actually predicting that negative economic ramifications will likely be worse for Europe (having lost the UK) than for the UK having just left Europe.

Some countries in Europe, led by France and Brussels, want to make leaving the EU as painful as possible for Britain, in order to discourage other countries form doing the same. I expect that once tempers settle down a little, they will retreat from this stance a bit. France also wants Paris to become a new banking center, and is trying to entice banks in London to make the move. However, the tax system in France is entirely less than favorable and will prove to be a strong deterrent.

Meanwhile, both the bank of England and European Central Bank have pledged to do whatever is necessary to stabilize the corresponding economies. Here in the US, with Janet Yellen having recently stated that Brexit was the single greatest threat to the global economy in 2016, I would expect that December is the absolute soonest we could see another rate increase here in the US.

Key Takeaways:

  • Global equities are down, and US treasury prices are significantly higher in a flight to quality
  • Expect significant volatility in the market in the short term until we settle into new yield levels
  • A lot of negotiation has yet to take place, but markets are already signaling that this will be worse for Europe than for the UK
  • Soonest we could see another rate increase in the US is December

Eric Swanson, CFA