Prior Week Summary
The U.K. confounded the financial markets last week, after a majority of voters expressed their desire to leave the European Union. As the news trickled in, and the outcome more apparent, assets across the globe repriced dramatically as the market’s oldest nemesis, uncertainty, drove investors to promptly recalculate risk premiums. Safe haven asset pricing soared, while the Pound and global equities gapped sharply lower. The implications of the vote will take time to become apparent, but have the potential to be far reaching in scope both economically and for the politics of Europe. In the starkest example since the global financial crisis and its aftermath, the reaction to the outcome of the vote highlights the market’s collective weakness in forecasting and discounting future events. It is these times of stress that highlight the critical importance of proactive strategic planning and risk-management.
To put the magnitude of the re-pricing of the Pound in context, the chart on the right shows 25 years of history in the GBP/USD time series in terms of the standard deviation of equally weighted daily price changes on a rolling 3-year time-frame. The re-pricing was a stunning 15 sigma event that drove interest rates in the U.S., Germany, and Japan meaningfully lower. Intraday, the 10-year Treasury traded within a basis point of its July 2012 low and the 10-yr Bund moved into negative territory. The 10-yr note traded in a wide 34 basis point range amid elevated trading volumes. As we’ve pointed out before, the frequency of intra-day market volatility of this magnitude has increased appreciably in the years following the financial crisis.
The combination of strong flight-to-quality flows, heightened uncertainty, the downgrading of the outlook for global growth, the tightening of financial conditions, as well as the perception of decreasing likelihood of Fed hikes drove intermediate Treasury yields lower by 15-20 basis points. The curve flattened meaningfully, narrowing an additional 15 basis points between the 10-yr Note and 3-Month Bills. Accordingly, bank stocks underperformed the broad market by nearly 4% on Friday as the perception for an extended low rate/narrow spread environment increased in likelihood. The many financial institutions that had positioned their balance sheets for a gradually rising interest rate environment may need to revisit their macro risk position at mid-year, with rates lower by over 70 basis points at the 10-yr point since the start of 2016.
As a result of the market movements and the uncertain implications of the “Brexit”, the implied probability for the next Fed rate hike has been pushed out into 2018 as the likelihood for a cut has grown markedly. Calculations made by Bloomberg indicate that the probability for a Fed cut have actually eclipsed those for a hike by the end of this calendar year, and several economic forecasters have downgraded their views to incorporate this potential.
It is reasonable to anticipate that the uncertainty associated with the U.K. referendum could cause elevated volatility in financial markets to persist for an extended time-frame as the political and economic implications filter their way through the market. The moves in rates may create opportunities for management teams as well as uncover hidden risks in the balance sheet. Long-term planning is most difficult during periods of stress and low visibility, but critically important in this difficult and volatile operating environment.
The Look Forward
Data releases will continue to carry less than average market significance this week, as the fallout from the U.K. referendum takes center stage. During the week, updated data releases are expected on 1st quarter GDP, the housing market, as well as personal income and spending. The Fed’s Yellen, Powell, and Bullard are all scheduled to speak on the state of the economy and financial markets early in the week. Good luck.