Our title today comes from the great British comedy team, Monty Python. I think it is very fitting to conjure up Monty Python the Monday morning after the historic and shocking victory of Brexit (Britain’s referendum to leave the European Union). After all, Monty Python was famous for going after the ruling elites of the United Kingdom. Last week’s victory by the forces of Brexit over the forces of “Bremain” just wasn’t supposed to happen, at least not in the minds of the UK’s top bankers, investors, and government. After bludgeoning the “common folk” with dire warnings of recession, job loss, reduction in public services for the poor, the Bremain side thought they put the capper on by hauling out soccer star and public icon, David Beckham, to lecture the masses on the dangers of leaving the EU.
How could the Bremain forces go wrong with good old “Becks?” Well, in my mind, all it did was show just how out of touch those in power continued to misread the anger and frustration of the forces behind Brexit. If the “elite” wanted to win the masses over with a soccer superstar, they should have brought out someone like Wayne Rooney drinking pints of beer and saying something like, “Look mates, if we Brexit, your football side may lose a lot of those fancy European players and ruin the Premier League!” That might have done something as opposed to kale eating, elite-hobnobbing David Beckham!
Seriously though, Brexit is a complete shock to the global financial system. The price action we are witnessing now, with major global stock markets down anywhere from 3–9%, the British Pound trading at levels not seen since 1985, German 10-year Bunds yielding negative 10 basis points, and the five-year U.S. Treasury Note trading below 1.00% are just jaw dropping. I have not seen this type of a global meltdown since the fall of Lehman Brothers in 2008. Is Brexit another Lehman Brothers event? At first glance, I would say it is not. However, there is the potential for real systemic risk.
The response to this event by the European Central Bank (ECB) and Bank of Japan (BOJ) may be very swift and painful. The BOJ watched the Yen fall below 100 Yen to the U.S. Dollar (USD) last night and the Nikkei fall 8%. The BOJ may decide to cut their policy rate—already negative—and increase Negative Interest Rate Policy (NIRP). This policy has been very damaging to Japanese banks. A cut will just increase the pain and risk.
Meanwhile, the ECB will (in my opinion) cut their deposit rate, currently at negative 40 basis points as soon as early next week. European banking giant Deutsche Bank—already wobbling before Brexit—may be in serious trouble if more NIRP is added to the mix. Deutsche Bank is bigger and more integrated with the global financial system than Lehman ever was. The thing about banks like Deutsche is, quite frankly, we don’t know what we don’t know. When we get to that state of mind, we get a loss of confidence in the financial system, which could in turn do serious damage to the global economy just like it did in 2008.
This morning, we are in a full flight to quality rally in treasuries. The two-year treasury yield got as low as 50 basis last night. The 10-year broke through 1.50%. These rates are probably too low, but in times like these, we’ve learned just about anything can happen. There is just too much confusion and when confusion reigns, a two-year Treasury note is like a security blanket and pacifier rolled into one! I will say that if we manage to stay below 1.55% on the 10-year for more than just a day or two, we can definitely see a U.S. mortgage refinancing event, which could result in a demand for interest rate duration from mortgage servicer and mortgage derivative hedge funds, which in turn could bring the 10-year Treasury yield to 1.45%. However, keep in mind that the 10-year has to stay in the low 1.50’s for the next three to four days for this event to happen.
Finally, here is something we saidin our Insights piece on June 6:
“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.”
Guess who is in Scotland today saying there are strong parallels between himself and Brexit? Donald Trump!
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