The historic Brexit vote on June 23 sent shockwaves through the capital markets and sparked a global flight to quality in fixed-income sectors, as investors reacted to new political and economic uncertainty.
Substantive, fundamental impacts on trade and economic growth are likely to take time before they become apparent. In the meantime, investors will likely have an elevated perception of risk and we believe central banks will react accordingly. Following what is now a well-known script, central banks are likely to respond with renewed measures aimed at keeping financial markets on “Novocain.”
Reduced rate-hike forecasts
Just one month before Brexit, both the market and comments by U.S. Federal Reserve Chair Yellen pointed to a rate hike by July 2016. Following the announcement of a weak U.S. payrolls number in May, the market lowered its rate-hike expectations and Yellen softened her previous more-hawkish tone. Moreover, over the past few years, the market has consistently been more skeptical than the Fed about the prospect for rate increases. Exhibit A shows that
the Fed’s “dot” forecast1 for fed funds as of December 2017 dropped from 2.4% at December 2015 to 1.6% at June 2016. The market’s expectations, as indicated by fed funds futures, fell from 1.4% to 0.45% over the same time frame.
The Fed took its first step toward tightening in December 2015, but that now appears to be on hold. Post Brexit, there is little reason to believe that monetary policy in Europe won’t continue to be in a highly accommodative mode, pushing some sovereign yields further into negative territory. Many have questioned the effectiveness of unconventional monetary policy measures pursued by the world’s major central banks, due to their apparent limited impact in spurring economic growth. However, there is little doubt such measures have caused risk assets to rally. For example, in the U.S., actions by the Fed can take much credit for double-digit increases in both the U.S. stock and high-yield bond markets. From 1 January 2009 through 31 December 2014, the S&P 500 had an average annual total return of 17.2% and high-yield bonds, 16.0%, based on the Barclays U.S. Corporate High Yield Index.
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