The surprise decision by UK voters to leave the European Union has resulted in global volatility that will persist for the short term and lead to a two-way division in the performance of core and periphery bond markets, according to Western Asset Management.
In a whitepaper discussing the impact of the Brexit, Western Asset’s Head of Investment Management London, Andrew Belshaw, says this historic decision will reshape and continue to send shocks through the market.
“This is a clear negative for the GBP, and the uncertainty over future trading relationships will lead to a weaker sterling. The Bank of England will have to adopt a more expansionist monetary policy to stabilise financial markets and shore up confidence in the wider economy. In the short term, this should cause British government bond yields to decline, but in the medium term it should steepen the UK yield curve as risk premiums are built in against further capital flight and inflation risk,” said Mr Belshaw.
“Core markets, especially Germany, should attract a safe-haven bid, driving yields lower and taking the yield curve further into negative territory. Periphery yields should rise as the rise in probability of further countries leaving the EU is factored into spreads.
“We expect corporate bonds, high yield and equities in the European market to weaken as exporters are weighed down by uncertainty and a lower growth outlooks takes a toll. We do however believe the ECB may ultimately backstop risk markets,” said Mr Belshaw.
The impact in Australia
Commenting on the impact from an Australian point of view, Western Asset head of Australian Operations Anthony Kirkham said the Australian economy is not directly linked to Britain or Europe, therefore any fallout is very much dependent upon the indirect impact to global markets.
“Central Bank action from around the globe is certainly possible, but in an effort to avoid instilling a sense of panic, is likely to be somewhat measured. In relation to Australian markets, we saw a jump in volatility in sympathy with moves in global risk markets.”
Three year bond futures rallied by around 23bp, with 10 year futures rallying around 25bp on the day of the announcement. The Australian iTraxx index, which began the day in the mid 120’s widened to trade at 142bp. From a currency perspective, the AUD fell approximately 3.5% to reach a low of US73c upon the announcement, retracing to US74c by late Friday afternoon.
“The fall is partially attributable to the unwinding of risk-on positions taken ahead of the vote. We expect the increased volatility and continuation of risk-off sentiment to continue in the near term,” said Mr Kirkham.
“With respect to domestic credit spreads, we expect to see continued widening in the short term. Much of the increased volatility will be restricted to synthetic bonds, as investors continue to hold cash bonds rather than sell into the weaker market. Cash spreads are also likely to widen, although in a more restrained fashion.
“Overall, volatility is likely to continue until the market gets a better understanding of the medium-term implications of the decision; including any potential central bank response. We expect liquidity in AUD markets to remain challenging in the near term, with any direct impact on the Australian economy and domestic credit markets from the decision likely to be limited.”
The full whitepaper, ‘The UK has voted to leave the EU’ can be found here.
