What a difference a day makes
How are the events of 23 June 2016 shaping current and future UK monetary policy? Ahead of the European Union (EU) membership referendum, the outlook for the UK’s economy was for a period of steady growth (albeit sub-par), underpinned by rising employment, wage growth, low inflation and an improving global backdrop. The UK was one of the best-performing developed economies leading up to June.
A remain vote was expected to maintain the status quo. In the US, the Federal Reserve had embarked on the early stages of a tightening cycle, with unemployment below its target for sustained growth and a raft of other macro indicators showing the economy was strong enough to handle higher interest rates. Even the euro zone, weighed down by the systemic fallout from the financial crisis, was beginning to show signs of turning a corner. It was all looking so positive until the shock result to “leave” the EU.
A leave vote was touted as being bad for both the country and equity markets. In the immediate aftermath, this proved to be right with the FTSE 100 falling sharply. Yet it soon recovered on the back of defensive stocks and companies that had meaningful international business models with the steep decline in sterling translating to higher repatriated earnings (figure 1).
What is good for equities is bad for bonds, right? With an uncertain outlook for the UK economy and the possibility of a Brexit-induced recession, Moody’s downgraded the UK from its top AAA credit rating. UK government ten-year bond yields fell sharply to 0.73% and, at the time of writing at the beginning of August, they are just 0.66%.
This rally was partly fuelled by expectations that the Bank of England would embark on a new round of monetary stimulus. After no action at the July Monetary Policy Committee meeting, August saw the central bank vote in favour of cutting interest rates to 0.25%, an increase of £60 billion in quantitative easing and a £10 billion corporate bond programme. But the UK was not alone in breaking records. European benchmark bonds also rallied with the ten-year German Bund yields falling below 0% to -0.19%.
It is not just economic news that has been surprising. Within a week of David Cameron’s resignation, Theresa May had been appointed prime minister and immediately began reshaping the cabinet and meeting her German and French counterparts. May has said she will not invoke Article 50 of the EU Treaty until 2017, after which will follow at least a couple of years of global trade negotiations.
All this lends itself to a protracted period of uncertainty, which will probably only serve to underpin the “lower for longer” interest rate position and consequently low bond yields. Even so, there are risks to this scenario. Inflation is below the Bank of England’s 2% target, but with the recent rally in energy prices and the weakness of sterling, that situation could easily reverse, forcing it to act. A deeper economic slowdown at a time of high and expanding government deficits may also prompt rating agencies to lower credit ratings further.
One thing of which we can be certain: market volatility will be heightened until we are through the new global trade negotiations.