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A Noble Experiment Gone Horribly Wrong


Brexit. This is the latest monetary phrase to strike fear into the hearts of the global financial markets and economy. On June 23, voters across Great Britain will decide whether or not to leave the European Union (EU). For the first time, polls across the country this week have indicated a majority favor leaving. If Great Britain leaves the EU, it will definitely cause turmoil in the financial markets and the economies of Great Britain and the EU. How much? Nobody is really sure, which is actually worse than being sure. Unknowns of this magnitude are a very bad technical, as if we needed another one.

Yesterday, as I watched European Central Bank (ECB) Governor, Mario Draghi, describe the Eurozone economy effectively dead in the water and implore the world to wait for the latest twist of Quantitative Easing and new lending facilities to take hold before rendering judgement, I realized you can’t really blame the British people if they decide it’s time to go. Jamie Dimon, CEO of JPMorgan Chase, was in Britain today with Chancellor of the Exchequer, George Osborne, speaking to JPM-Chase staff about the merits of staying. He called the European Union “One of the great human endeavors of all time.” He also told his staff of 16,000 that if the leaving vote wins, 4,000 of the staff may be leaving as well!

Personally, I agree with Mr. Dimon that the European Union was a great endeavor. However, somewhere during this endeavor, the dream became a nightmare. In 1985, I spent a semester of college studying in Brussels where our main academic focus was on the European Union. Back then, the idea of letting Spain and Portugal into the EU was violently opposed by the most powerful member of the proposed union, West Germany. West Germany thought Italy was a stretch! In fact, and I swear this is true, one of the German officials who came to speak to us said, “If we let Spain and Portugal in, we might as well go all the way and let Greece in!” He then laughed. 

Eventually though, I think the benefits an exporting giant like Germany could gain by diluting their currency (exchanging the Mark for the Euro), and gaining a whole market of new “countrymen” like Spain, Portugal, Italy, Ireland, and Greece (now able to borrow at very low rates as members of the same family as Germany) buying what Germany was making, won the day. Many shady things happened along the way to creating the union. The stronger members looked the other way while countries like Greece and Italy used bogus derivative contracts to make their budget deficits meet the guidelines for entry. In fact, EuroStat, the agency tasked with checking all member country’s books for compliance, actually allowed these bogus interest rate and cross currency swaps to be used up until 2008!

I think the citizens of the United Kingdom (UK) are going to vote to leave. People are fed up all around the world. Honestly, if I asked you in 2015 what would have a better chance of coming to fruition—the UK voting to leave the European Union or Donald Trump winning the 2016 Republican nomination for president—what would you have answered? Both odds were pretty low. However, Brexit would have been higher. Well, Donald Trump won the nomination, and now it is Brexit’s turn. To some degree, both the Trump presidential run and Brexit are one in the same. Many people are fed up to the point where they are demanding that the current “system” be smashed to smithereens. In the United States, it is Donald Trump (as well as Bernie Sanders), and in the UK it is Brexit. I think it is critical to factor Brexit into your risk outlook because I believe it is going to happen.

This morning’s employment numbers were pretty shocking to the market after a long string of employment growth. The consensus was an increase to employment rolls for May of 160,000. Instead, we got 38,000. Personally, I thought the numbers were going to surprise to the downside, based on the weak employment data we were seeing in national and statewide manufacturing data. Furthermore, there still is such a thing as an economic cycle. It confounds me that the Fed hasn’t addressed the possibility that employment growth would eventually slow down, considering increasing declines in business investment. The rates markets are reacting as you would expect after such a number. A lot of investors were short the front-end of the yield curve and long the back-end. This was the correct play if you thought the Fed was going to raise in June or July and then maybe once more in December.

Now, a lot of those positions are getting stopped out. The two-year Treasury is down 12 basis points in yield since the number came out, now yielding 77 basis points. Right now, the market is all about bad positions getting closed out in a market far less liquid than it was pre-financial crisis. I think the rally in the front end is a bit overdone. However, I continue to like the 10-year and the 30-year points on the curve (although this morning’s rally is probably overdone as well, but not by much), and I continue to like long-dated, high-quality bonds like municipals.

Image by Vaughan Leiberum from Cape Town, South Africa - Flag - Great Britain (cropped), CC BY 2.0

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