Did you know that the United Kingdom has the fifth largest Gross Domestic Product (GDP) in the world, and the GDP of the remaining European Union countries combined is the world’s third largest? The European Union, including the United Kingdom, accounts for the world’s second largest GDP. I think most people had an idea of the magnitude of their economy when the citizens of the UK went to the polls and shocked the world by voting to leave the Union or “Brexit” in late June. The reaction to the news was a violent selloff in risk assets and a huge flight to quality rally in U.S. Treasuries and German Bunds. The thought of the second largest economy in the world losing its second biggest member intensified the specter of substantial slowing of European economic growth (which was already slow to begin with), and heightened a huge realm of uncertainties in a world already chock full of uncertainty.
Then, as is often the case, after seeing that neither the European Union or the UK sunk beneath the waves of the Atlantic over the summer, many in the investment and central banking world put the event in the rearview mirror with a big, ‘Well, thank heavens that bit of nastiness is over.’ The sad fact is, the nastiness had not even begun, until now. This week, Prime Minister Theresa May indicated the path to Brexit will begin when she triggers Article 50 of the European Union’s Lisbon Treaty in March 2017. The Prime Minister seemed to be taking a pretty hard line this week when she said:
“Let me be clear. We are not leaving the European Union only to give up control of immigration again. And we are not leaving only to return to the jurisdiction of the European Court of Justice. Those who want to do everything to preserve access to the single market are looking at Brexit the wrong way.”
Many in the UK and Europe thought the Prime Minister would present a model of Brexit where the UK accepts what are described as the “Four Freedoms:” the freedom of movement for goods, services, capital, and people in exchange for continued special access to the European Union.
But, she didn't.
Furthermore, the response language out of the capitals of Europe have taken the tone of, “Fine, pack your bags and get out!”
Since Ms. May’s speech, the British Pound (GBP) has dropped a whopping 4.3%, including a flash crash Thursday night when the GBP dropped 6.1% in a few minutes! The currency rebounded quickly by about 4%. Market observers blamed the event on the proverbial “fat finger,” which is when a trader intends to sell a thousand contracts and accidentally enters a trade to sell one hundred thousand contracts. It happens. However, currency trading desks are reporting that the trading volume for the overall session was just too high to blame it on a fat finger since we still ended up down more than 2%. The currency’s rapid depreciation is putting obstacles in front of the Bank of England’s (BOE) stimulus plans to help the UK economy through the pitfalls of Brexit. As a result, the UK 10-year bond has increased approximately 21 basis points in a week, dragging global bond yields up with it. Brexit is going to be a long, drawn-out, nasty affair, and it will depress economic growth in the UK and Europe for quite a while, I believe.
Another event this week that pushed up global yields (the U.S. 10-year Treasury increased 11 basis points in yield while the 10-year German Bund increased 14 basis points) was a rather silly response to a rumor. Not a story, mind you, but a rumor which was that the European Central Bank was discussing tapering quantitative easing (QE) bond purchases prior to the end date of the program. This unsubstantiated rumor immediately assumed the worst. Bill Gross went on CNBC screaming that Europe was ready to have its own version of a “taper tantrum” (the U.S. had a violent bond selloff in the spring of 2013 when the Federal Reserve began discussing tapering purchases of bonds as a lead up to ceasing buying new bonds for its QE program), and the long end of our Treasury curve sold off in sympathy with Bunds. Some investors took the earliest date the ECB had stated they would end the purchase of new bonds, March 2017, and then counted backward, thus determining that the ECB was going to taper buying bonds now.
The whole thing was completely ridiculous. The biggest problem that the ECB has been advertising regarding their QE program is that they are running out of bonds to buy! The ECB took a day or two to communicate to the markets that the rumor was just that, a rumor. ECB officials said that they haven’t even discussed the idea of tapering. Additionally, right from the beginning when this stupidity started, people seemed to forget that the ECB has said repeatedly that March 2017 was the earliest end date for QE new bond buying, and they could extend it as they see fit. Sure, the ECB could have talked about tapering (which it turned out, they didn’t) but it would have probably been in the context of, “We are having a hard time finding 80 billion bonds a month to buy. Let’s push the end date out six months and buy 40 million a month.” The markets are still a bit roiled, but I think the ECB meeting on October 20 will put things to rest. Global central banks are still buying more bonds than are available and that isn’t changing for a long while. I am still bullish on the long-end of the Treasury curve.
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