Bond market reaction to UK “Leave” vote

The UK has voted to “Leave” the EU.  We’re seeing some significant moves in fixed income assets first thing this morning as financial markets had very much discounted a “Remain” outcome, in line with the last opinion polls and in particular the betting markets which had heavily backed that outcome.  The biggest market movements though have occurred in the FX markets where the pound fell from nearly 1.50 to 1.36 versus the dollar, lows not seen since 1985.  The US dollar index has rallied by nearly 3%, and the big winner in this “risk off” scenario has been the Japanese yen, itself now up 3.6% against the US dollar.  The Euro is performing badly as both the economic and political implications of the “Out” vote are digested – will European growth be hit, will other EU nations hold their own referendums, what will become of the periphery and the banking sector?  The Euro is down by over 3% against the dollar.  In a risk off morning, the other big losing currencies are those in emerging markets.  The Mexican peso for example is 6% weaker.

Within bond markets themselves, the US 10 year Treasury has rallied by 25 bps (more than two points) overnight, and the 10 year bund has moved sharply back below zero – now trading at a new record low of  -15 bps.  This follows Thursday’s sell-off in government bonds in anticipation of “Remain”.  Gilt markets will also rally when they open at 8am, and all eyes are on the Bank of England which has committed to keep the banking sector awash with liquidity.  I wouldn’t rule out a rate cut from the BoE later this morning, perhaps to 0% from 0.5% (although this would likely trigger a further sell off in sterling).  A likely ratings downgrade for the UK has been flagged in advance in the event of a “leave” vote – markets have generally not punished downgrades on highly rated sovereigns (for example the US when it lost its AAA rating).  There is no significant default risk for a nation which can print its own currency.

The “losers” in bond markets are the riskier fixed income assets.  As further EU breakup fears grow, Italian and other peripheral government bonds are underperforming.  Italian and Spanish 10 year bond yields have risen by 30 bps so far this morning.  Peripheral financial bonds are perhaps 60 bps wider in spreads at the senior level and up to 130 bps wider at the subordinated level.  Banks in general, even in “core” nations, are also performing poorly relative to traditional corporate bonds.  Senior bank debt is 50 bps wider, and subs are 100 bps wider.  Corporate bonds are anything from 20 bps to 80 bps wider.  There has been talk of institutional buying at these lower levels, although we are sceptical that there has been much trading so far today.  Emerging market bonds are all much lower.  Turkey’s US$ debt is off 2 points, South Africa 3 points and Hungary 6 points.  The high yield market was extremely weak initially, with the Crossover index at one point 120 bps wider.  It’s retraced some losses and is “just” 80 bps wider now.

Fundamentally the sell-off in risk assets presents some opportunities for long term investors.  Credit markets were already discounting a much higher level of defaults than we believed likely, and today’s moves increase the over-compensation for default risk.  However, with liquidity likely to be low today (and potentially for some days to come as the implications of yesterday’s vote become clearer) the chance to pick up bargains might be limited.

What about the economy?  Well 90% of economists expected a “leave” vote to be negative for UK growth.  Some say that even the uncertainty leading up to the vote took up to 50 bps off GDP growth.  Certainly investment intentions are likely to be delayed by businesses, and households may become more cautious.  A recession can’t be discounted.  With the global growth outlook also now likely weaker we expect the US Federal Reserve to be on hold.  No rate hikes for the foreseeable future.  UK inflation is a different matter.  A fall of this magnitude in the pound will lead to higher import prices.  After years of inflation being below target, it should move higher than 2%.  However in the interests of growth and financial stability this is unlikely to provoke a response from the Bank of England: as mentioned earlier a rate cut is more likely in the first instance.

Finally I am cross that there was nowhere open to buy caffeine on Cannon St at 6am this morning.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Jim Leaviss

Job Title: CIO Public Fixed Income

Specialist Subjects: Macro economics and fixed interest asset allocation

Likes: Cycling, factory records, dim sum

Heroes: Brian Clough, Morrissey, Neil Armstrong

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