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Brexit: Q and A

Special

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  • The British people have cast their vote to leave the EU
  • Pound sterling has already dropped to its lowest level since 1985 and volatile markets can be expected in the aftermath of this decision
  • In this Special we discuss the likely next steps and the near-term ramifications for global financial markets in a Q&A format

Shock! (and awe?)

In what has been a very tight race, the British people have decided that Britain should leave the EU. Although the ‘Remain’ camp received strong backing from the business sector and international organisations (and more generally had run a campaign targeted at the homo rationalis), the ‘Leave’ camp, which put a strong emphasis on self-control and sentiments that struck a chord with disgruntled voters, ultimately prevailed. A new chapter in UK economic history is about to commence and financial markets will watch any further political gyrations with elevated scrutiny.

In this Special we aim to answer the immediate questions that arise now that the British people have cast their vote. We discuss the likely next steps and the ramifications for (global) financial markets. We do so in a Q&A format. The reader can jump immediately to the questions (and our answers), using the menu below.

Section A – Process and next steps

1.   What are the political ramifications for the current government?
2.   What are the next steps the UK government will have to take?
3.   How will the EU respond - will it be co-operative or non-cooperative?
4.   What possible trade models are most likely/feasible in the aftermath of a ‘Brexit’?

Section B – Monetary policy response

5.   Will the outcome of this vote affect the payment system?
6.   What is the most likely immediate response by the Bank of England?
7.   How will other central banks respond?

Section C – Implications for financial markets

8.   What will be the impact on pound sterling?
9.   How will other currencies react?
10. Will this referendum outcome lead to a cut in the UK’s sovereign rating?
11. What will be the impact on UK long-term rates and credit spreads?
12. What about corporate credit spreads?

Section A – Process and next steps

So, what will happen now? It’s impossible to accurately predict this, for the most part because this is uncharted territory for both the United Kingdom and the European Union. It remains to be seen whether the UK government sets the exit-wheels in motion straightaway, while we expect the EU to take a tough line. Despite that, there will be increased speculation that other countries will follow the same route as the UK.

 

Q1. What are the political ramifications for the current government?

Prime Minister David Cameron has some serious credibility issues and that there is a clear risk he will be forced to resign, even though he has repeatedly said he won’t. Below are three reasons why his position appears untenable.

  1. Cameron never really wanted this referendum to take place anyway. It was promised to the British / Tory electorate as part of the Conservatives’ response to the rise of the eurosceptic UKIP party in a bid to sooth the unrest within the Tories’ ranks. The surprising outright win at the 2015 elections may in part be the result of this bold move, but the absence of the Liberal Democrats in a coalition also pushed Cameron in the unfortunate position to live up to this promise.
  2. Cameron subsequently decided to actively campaign for “Remain”, explicitly stating that he believes that Britain will be “safer, stronger and better off by remaining in a reformed European Union”. Obviously, the British people have rejected his point of view.
  3. The voters’ rejection can also be read as a vote of no confidence in the outcome of the negotiations between the UK and EU, which were led by Cameron. While he extracted some concessions from the EU, they weren’t sufficient to ensure a “Remain” outcome. Having first negotiated to “Remain”, Cameron simply isn’t in the right position to now negotiate a “Leave”.

Cameron has already indicated that he won’t participate in the 2020 elections. Needless to say, there are numerous people within the conservative party that are after Cameron’s head right now – most notably Boris Johnson, the former mayor of London. Those who have campaigned in favour of a Brexit obviously have more credibility, which they will undoubtedly use in an eventual leadership election. A new Conservative leader would have a much better mandate in negotiating with the EU.

There are those who believe the referendum outcome is not necessarily final and instead can be used as an ultimate bargaining chip to extract far-reaching concessions from the EU. Indeed, Boris Johnson has suggested as much in the past, speaking of a new “Grand Bargain”. We think such disregard of the voters’ clear wishes is very unlikely and politically unfeasible.

Q2. What are the next steps the UK government will have to take?

This obviously hinges on how internal politics evolve in the direct aftermath. If there will be a leadership contest between several Tory prominents, there’s a good possibility that the exit talks with the rest of the European Union will be put on hold until the UK has a leader with a properly defined mandate. This would create months of additional uncertainty in the market.

The first big decision involves when to invoke Article 50 of the Lisbon Treaty. Cameron could swiftly kick this one off to underscore that a vote to leave is indeed just that. He could already do this at this weekend’s summit in Brussels. But it remains to be seen whether he feels qualified to take such a step at this stage, or considers it in Britain’s best interest to take a more patient approach. European leaders, on the other hand, will push for clarity on this front. The relevant article then offers a road map for Britain in the coming two years, but it is very loosely formulated (see Box 1).

Once the UK government invokes Article 50, the UK would immediately lose its seat on the European Council, which comprises all other heads of states. This means that the UK loses a lot of its leverage and from there on has a much reduced say in European politics. Secondly, it will also start the clock on a definitive exit in just two years’ time, unless all other Member States unanimously decide to extend this period. This, however, appears to be highly unlikely.

Arguably, this isn’t the best starting point to commence such complex and time consuming negotiations. In fact, it may provide an incentive for the UK government to stall the invocation of Article 50 for as long as is realistically possible. Note that the referendum is non-binding; it does not compel the government to set the exit-wheels in motion right away. But we again would like to stress that the UK government cannot stall this indefinitely, as such a disregard of the voters’ clear wishes is politically unfeasible.

Box 1:  Article 50 of the Treaty of Lisbon

  1. Any Member State may decide to withdraw from the Union in accordance with its own constitutional requirements.
  2. A Member State which decides to withdraw shall notify the European Council of its intention. In the light of the guidelines provided by the European Council, the Union shall negotiate and conclude an agreement with that State, setting out the arrangements for its withdrawal, taking account of the framework for its future relationship with the Union. That agreement shall be negotiated in accordance with Article 218(3) of the Treaty on the Functioning of the European Union. It shall be concluded on behalf of the Union by the Council, acting by a qualified majority, after obtaining the consent of the European Parliament.
  3. The Treaties shall cease to apply to the State in question from the date of entry into force of the withdrawal agreement or, failing that, two years after the notification referred to in paragraph 2, unless the European Council, in agreement with the Member State concerned, unanimously decides to extend this period.
  4. For the purposes of paragraphs 2 and 3, the member of the European Council or of the Council representing the withdrawing Member State shall not participate in the discussions of the European Council or Council or in decisions concerning it. A qualified majority shall be defined in accordance with Article 238(3)(b) of the Treaty on the Functioning of the European Union.
  5. If a State which has withdrawn from the Union asks to rejoin, its request shall be subject to the procedure referred to in Article 49. 

Q3. How will the EU respond - will it be co-operative or non-cooperative?

We think it’s best to frame the EU’s strategy regarding the UK in the coming period as either cooperative or non-cooperative. From a rational point of view, EU member states will have the incentive to contain the economic fall-out from a Brexit for as much as possible. “What is bad for Britain, is bad for Europe” may sound as a huge oversimplification, but in essence it is true. A “clean” exit, in which new and comparable trade arrangements are swiftly put into place, would therefore be preferred. This cooperative strategy limits the short-term economic and financial uncertainty and it would be just a matter of time before business resumes as (almost) usual. However, even though the economic recovery in the Eurozone rests on a very thin foundation, and should therefore be handled with the utmost care, one must take into account that economics only make up part of the equation.

It’s not unrealistic to think that policy makers will choose to put the economic recovery at risk in exchange for the greater good: a continued push towards an “Ever Closer Union” that should maintain the coherence of the remaining EU27. This implies that the EU may seek to be relatively tough on the UK in order to reduce the incentives for other EU member states to follow a similar path. This would lead to far worse arrangements, for both the UK and the EU in economic terms, but may benefit the cohesion and the functioning of the European Union in the long-run. Moreover, keep in mind that it would take the goodwill of 27 countries to be cooperative and only the stubbornness of one country to be non-cooperative.

We expect the EU to take a tough line. Given the widespread rise of populist and eurosceptic parties across the continent, we expect that most Member States will showcase a hawkish approach. Please note as well that there are elections coming up in Spain (next week), the Netherlands (March 2017), France (Spring 2017), Germany (August 2017) and Italy (no later than May 2018).

The European Union also needs to think about its internal strategy. Following Britain’s invocation of Article 50, the 27 remaining EU Member States could then decide:

a) To increase the speed of political and economic integration. This potentially has been made easier now that the UK has lost its influence on the European Council and should strengthen the EU’s political clout – both internally (single market) and externally (geopolitics, trade, etc.). However, this may raise opposition by smaller and/or peripheral Member States if this implies greater power for the German-Franco axis (with emphasis on the German side of the ledger).

b) Or to maintain the status quo. Even though some would say that this soothes the Eurosceptics’ concerns of an Ever Closer Union, we think that this would risk leaving the Eurozone exposed to Brexit-unleashed forces that will widen the cracks within the EU. If so, we could see further political turbulence and possibly the re-emergence of significant Eurozone break-up premiums in financial markets. Please note that European politics has a tendency to go for the status quo.

Nevertheless, there will be speculation that other EU member states will now be at risk of going down the same route as the UK. A Brexit would break the trend of the Ever Closer Union and could contribute to an erosion of EU cohesion. It may also contribute to the creation of a two-speed Europe in which subgroups of countries would opt for varying degrees of cooperation. It might also lead to a rebalancing of power in favour of France and Germany, at the detriment of proponents of relatively more liberal economic policies.

Q4. What possible trade models are the most likely/feasible in the aftermath of a ‘Brexit’?

We take look at three possible scenarios to get a feel for the variations possible: British membership of the European Economic Area (like Norway), a bilateral free trade agreement (like Switzerland or Canada) or, if the talks fail, no such agreement. We have outlined these scenarios in the table below. However, we need to stress that reaching these outcomes will require a lot of time and effort on both sides of the negotiation table and there are serious doubts about whether these outcomes can in fact be reached within the two-year period that is potentially available for this. In the run-up to the actual secession from the EU, it will be the uncertainty about the negotiation process that will be a source of volatility in markets. There is no indication that negotiators on either side of the table currently know where we will end up.

Section B – Monetary policy response

The monetary policy response is crucial when it comes to dealing with the immediate fall-out of the vote to leave the EU. An ill-chosen policy response could aggravate market gyrations, whilst a well-chosen one should help prevent liquidity issues, contain volatility in financial markets and limit the broader consequences.

Although the current situation does not lend itself for a direct comparison with 16 September 1992, when the British government was forced to withdraw the pound sterling from the ERM (European Exchange Rate Mechanism), there are some similarities. In particular, the British economy was – like today – also struggling with a twin deficit in the government finances and current account. These factors could be a source of volatility for the currency. However, compared to the early 1990s, inflation is very low right now, while pound sterling, is a freely floating currency at the moment. Bearing in mind the hands-on experience that has been built up since the onset of the 2008 Global Financial Crisis, there are good reasons to expect monetary policy to play a decisive role in containing the fall-out of the Brexit vote, in particular where it is related to market liquidity.

Figure 1: UK growth and inflation
Figure 1: UK growth and inflationSource: Macrobond
Figure 2: Current account and government balance
Figure 2: Current account and government balanceSource: Macrobond

Q5. Will the outcome of this vote affect the payment system?

We believe it very unlikely that the payment system will be affected in any way by the outcome of the referendum. Until the UK really leaves the EU, nothing will change. To keep markets running smoothly in these weeks, the Bank of England (BoE) has been offering three extra indexed long-term repo (ILTR) operations on June 14, 21 and 28 that provide six-month finance. These operations provide banks with unlimited liquidity to offset any shortages stemming from for example deposit outflows. This should enable banks to carry on with their normal business. We would also expect some form of a joint response in terms of liquidity and swap lines provided by other central banks, in particular the ECB and the US Federal Reserve. In the medium-term, i.e. after leaving the EU, Britain will need to transpose all SEPA agreements concerning European money transfers into its national legislation in order to guarantee the continuity of payments between the UK and Eurozone member states.

Q6. What is the most likely immediate response by the Bank of England?

Until a full agreement has been reached over the terms and conditions of a ‘Brexit’ (which could well take several years), there are unlikely to be any significant changes in either the legal, economic or financial environment that businesses are operating under. Nevertheless, the political response and the pronouncements made by officials will affect sentiment and raise uncertainty among consumer households and businesses. This uncertainty and now almost inevitable adjustment to a future outside the EU is likely to weigh on aggregate demand. This could be aggravated in case there are negative spillovers to global demand, which would reduce demand for UK exports.

Against this backdrop, we expect the BoE to signal a willingness to keep rates low for an extended period of time (whilst not excluding the possibility of a cut, or other additional stimulus measures) and to maintain liquidity facilities for as long as is deemed necessary. Compared to the other major central banks, the BoE still has some room for manoeuvre on the rates front, as the Base rate has been stuck at 0.50% since 2009. We should note, however, that the Bank has signalled that 0.50% has to be the bottom for the Bank rate for the sake of the balance sheets of building societies. Desperate times may call for desperate measures, we acknowledge, but it is therefore more likely that the Bank might contemplate additional quantitative easing as its first line of defence. Altogether, such a response would likely reduce UK short-term interest rates. This is based on the premise that concerns about a post-referendum fall in aggregate demand are to outstrip concerns about near-term inflation risks stemming from a weaker pound. However, were the pound to depreciate very strongly, the BoE may be careful in promising too much. After all, such a sharp currency depreciation could lead to a sizeable increase in import prices and, hence, generate a marked increase in inflation. However, given the subdued global as well as local inflation backdrop, an ‘ERM’ scenario does not look very likely at this stage.

Q7. How will other central banks respond?

One of the key themes that we have been running over the past year is that global growth remains slow and vulnerable to downside risk, because i) lacklustre productivity growth is largely structural in nature, ii) private and public sector debt is already (too) high and iii) monetary policy has been ineffective, in fact even counterproductive. We now seem to have reached a point where market participants are increasingly succumbing to this idea. The thinking here is that negative rates and quantitative easing policies are leading to a further misallocation of capital and raising the gap between the haves and the have not’s. This, in turn, is leading to an army of disgruntled voters everywhere. The slow pace of economic recovery, from which large parts of the population are not benefiting anyway, and the current geopolitical environment – felt in Europe through the migrant crisis – is creating fertile soil for political anti-establishment movements.

In our view, therefore, the main spillover effect from the ‘Brexit’ vote is that it will embolden political anti-establishment movements to make their voice heard. In the European context, this implies that there is a risk of a further widening of the cracks in the European Union (see also Q3). As such, the re-emergence of European Union, or even Eurozone break-up risk, could affect sovereign spreads and risk premia more generally. If these sentiments and heightened uncertainty about the global impact of Brexit turn into a renewed retrenchment by firms (i.e. a slowdown in investment) and households (i.e. more saving), the ECB may have to respond with additional easing measures. Although the ‘OMT’ programme is one option, it can only be invoked by a formal request for support by a member state. So more likely is that the ECB will first focus on ‘trusted and tested’ measures such as a further cut in the deposit rate and hints at a further potential expansion of QE. But this time around, we see it as less likely that a “whatever it takes” response by the ECB will be hugely effective. In fact, the ECB’s response could well raise concerns about the inability of central banks to respond to new negative shocks.

Heightened volatility in financial market will likely further reduce the chances of a near-term (July) rate hike by the Fed to nearly zero. Whether the Fed will still go ahead with a hike in September will remain strongly data-dependent. However, given that market expectations have already been adjusted down significantly, the Fed may have no incentive to talk down these subdued expectations as long as domestic fundamentals do not deteriorate markedly.

Figure 3: Inflow of portfolio and direct investment has supported a C/A deficit
Figure 3: Inflow of portfolio and direct investment has supported a C/A deficitSource: Macrobond
Figure 4: It wouldn’t be the first time that sterling drops sharply
Figure 4: It wouldn’t be the first time that sterling drops sharply Source: Macrobond

Section C – Implications for financial markets

The initial reaction by financial markets will be seen as an important gauge of how investors look at the UK’s prospects. Medium-term consequences for the economy could be significant. The UK Treasury has estimated that a Brexit would leave a GBP 36bn hole in public finances, equivalent to 8 pence on the basic rate of income tax.  In the worst case scenario UK GDP would be 5.4%-9.5% lower after 15 years. The CBI has stated that leaving the EU would lead to 950,000 jobs lost and leave an average household GPB 3,700 worse off by 2020. The Centre for Economic Performance has stated that in a most optimistic Brexit scenario (Britain adopting the Norway model), the costs of exit could be GBP 6,400 per household.

Financial markets’ typical leaning towards “shoot first, ask questions later” also implies that as long as it is unclear what alternative trade model the UK is exactly heading for, that very uncertainty by itself will be a significant drag on market sentiment. This could increase risk premia investors require on a wide range of UK assets and generate downwards pressure on the pound, particularly given that markets did not fully price in a Brexit in the run-up to the referendum.

Q8. What will be the impact on pound sterling?

Since the 1970s, sterling has experienced several crises (Figure 4). The 1992 ERM crisis and the 2008 GFC arguably belong more to the ‘black swan’ category than the current Brexit vote, if only because market participants have had at least the chance to hedge themselves. Nonetheless, sterling has already dropped 10% vis-à-vis the dollar in overnight trading as the referendum results have trickled in, to sit at its lowest level since 1985. We would see further downward pressure on sterling as other asset markets open, where another 5% depreciation from its current level of 1.34 is very well possible in our view. In the medium-term, downward pressures on cable may intensify in an uncertain political climate that is likely to follow. On a six-month horizon, sterling could then start to regain some ground once the dust has settled. Several factors inform our view on sterling: i) the UK’s current account deficit, which is now the largest on historical record, and how that has been financed in recent years, ii) the potential impact of uncertainty on the UK’s financial sector and iii) the likely response of the BoE.

First of all, the UK has been running a significant current account deficit in recent years (figure 2) which makes the pound vulnerable, notably in a situation where foreign investors take a “wait and see” approach. This current account deficit has been financed by foreign direct investment and portfolio flows (figure 3). A drying up in the former, but in particular a reversal in the latter could put downward pressure on the pound. The UK has been a popular destination for EM investors and to the extent that these investors have been viewing the UK as an excellent bridge head for mainland Europe through its EU membership, a ‘rethink’ on the position of the UK may also affect the pound more broadly. At the same time, a re-direction of inward FDI flows from the UK to other EU (mostly Eurozone) member states can support, albeit over a long-term horizon, the euro.

Figure 5: Concerns about EU cohesion could lead to re-emergence of Euro breakup premium
Figure 5: Concerns about EU cohesion could lead to re-emergence of Euro breakup premiumSource: Macrobond
Figure 6: A return of ‘global risk-off’ would imply lower commodity prices, weaker EM-FX
Figure 6: A return of ‘global risk-off’ would imply lower commodity prices, weaker EM-FXSource: Macrobond

Secondly – and this is a point that was also raised in the BoE’s May Inflation Report – around half of UK banks’ short-term wholesale funding is denominated in foreign currency. Heightened uncertainty may affect the availability of foreign currency liquidity. The BoE and other central banks are likely to provide sufficient backstops. Nevertheless, concerns about the future role of the UK’s vast financial sector in a new relationship with the EU is likely to weigh on sterling as well.

The exact impact obviously hinges on whether the UK will be able to strike a good deal with the EU. The main risk we see is that banks could lose their access to the EU internal market and their passport rights (mutual recognition of banking licenses). Non-tariff trade restrictions could thus hinder the export of financial services. If the UK loses their preferential access to the internal market and transactions with businesses and banks on the European continent become more difficult, (foreign) banks and other financial businesses may leave London for continental Europe or Ireland. It can be argued that this outcome would benefit eurozone members, especially those with big financial centres like France and Germany, and its monetary authorities. The City in London is currently the main trading centre for the euro, but its financial institutions fall under the authority of the BoE. If these financial activities move towards eurozone members, the European Central Banks’s (ECB) control over euro transactions will increase. These benefits could act as incentives for at least some eurozone members to block free trade of British financial services.

Thirdly, we would expect the Bank of England’s concerns about aggregate demand to outstrip concerns about the inflationary impact of a weaker pound (see Q6). In other words, the BoE’s initial response may not be in support of sterling.

Q9. How will other currencies react?

A Brexit is likely to have the biggest economic impact on countries that are connected closely to the UK through their mutual trade (both exports and imports). Those countries are Ireland, the Netherlands, Belgium and Luxembourg. In a global context, however, the Eurozone is obviously the most closely connected. This is likely to put downward pressure on the euro. Moreover, a global sell-off in risky assets due to higher risk premiums would likely support safe-haven currencies such as the yen, the Swiss franc and, to some extent, the dollar. We don’t expect that the euro will display such safe-haven behaviour. Indeed, in overnight trading, the EURUSD currency pair has already dropped from 1.14 to 1.10.

In addition, there is a risk of a domino effect after a Brexit due to rising Euroscepticism. A recent IPSOS-Mori survey showed that 45% of citizens in 8 EU countries want a referendum on the union and that 33% of citizens would vote “out” if such a referendum were held (with the latter percentage varying from as low as 22% in Poland to 41% in France and as high as 48% in Italy). A survey from Pew Research Center confirmed this and found that Euroscepticism is rising everywhere except Poland (!).

Therefore, we would expect sterling to fall less against the euro than against the dollar. This is also because the euro itself could suffer from the fall-out of the referendum results.

Depending on the UK’s relative economic fate following its exit from the block, other EU members may consider following in its footsteps or at least pushing for a renegotiation of EU treaties, possibly at the demand of local populist parties. In the event of friendly negotiations, these risks will increase. But if the EU negotiates a tough deal with the UK, this impact could be more limited. In any case the EU still has to negotiate trade agreements with the UK. As the remaining EU-members probably have different priorities during these negotiations and are interested in securing different agreements with the UK, this could lead to new discussions and disagreements between the remaining EU members. A setback or even stagnation in European integration would damage the strength of Europe as a block and its global position. In a worst case scenario, the EU/eurozone could fall apart. We regard the latter as only a remote possibility, albeit with an extremely high impact.

A re-emergence of a ‘Euro breakup’ premium, similar to the kind that we saw during the sovereign debt crisis, in particular in 2011-2012, can therefore not be excluded. This is especially so if the market has reasonable doubt about the ECB’s ability to address initial spread widening with its current policy settings, whereas the willingness among some Governing Council members to support the OMT may be low in the near term.

On a global scale, a sell-off in risky assets and general move towards safe havens is likely to see renewed downward pressure on EM currencies.

Q10. Will this referendum outcome lead to a cut in the UK’s sovereign rating?

Fitch ratings (UK: AA+ w. Stable outlook) have stated on 16 May 2016 that “the UK sovereign rating would be subject to review in the event of a ‘leave vote’ in the referendum on 23 June” (not its base case) and that “If favourable exit and trade agreements were reached smoothly and swiftly, Fitch believes the effect would be mildly negative after initial market volatility. However, protracted negotiation resulting in unfavourable terms would be more negative. A leave vote combined with subsequent Scottish independence would bring the UK’s rating under further pressure.”

S&P (UK: AAA/A-1+ w. Negative outlook) have said on 19 April 2016  that “the possibility that the UK could leave the European Union […] represents a significant risk to the UK economy, in particular to its large financial services sector and exports”. “If the UK were to leave the EU it may make financing its twin deficits more difficult, particularly its large current account deficit […]. A vote to leave would also likely lead to demands for another referendum on Scottish independence, leading to further uncertainty. The negative outlook reflects the possibility of at least a one-in-three likelihood of a downgrade over the next two years. A vote to leave is likely to hurt confidence, investment, and GDP growth, and is likely to have a negative effect on public finances. As a consequence, a UK departure from the EU […] would likely lead us to lower the long-term sovereign credit rating.”  S&P have also stated that should sterling’s role as a reserve currency diminish, it would likely lower its rating on the UK.

Altogether, there is a clear risk that rating agencies will reassess the UK’s sovereign rating, although the political developments in the weeks and months ahead will prove crucial. Fitch ratings have indicated that a decision will also depend on the process towards a break with the EU and as such might be less ‘trigger happy’. Their colleagues from S&P, on the other hand, have been more explicit, arguing: “Depending on the circumstances and consequences of a vote to leave, we could lower the rating by more than one notch if we reassessed our view of the UK’s institutional strength and ability to formulate policy conducive to sustainable growth”.

A sovereign rating downgrade for the UK could also have implications for other sovereigns, as a ‘Brexit’ would have negative implications for the economies of other EU countries. Moreover, the process towards an actual ‘Brexit’ could widen the cracks within the EU and even EMU. In the near-term, we think rating agencies will focus mostly on the UK itself. In a recent piece, our SSA strategist Matt Cairns assessed what a “Brexit scenario could mean for European SSAs”.

Regardless of the response by the rating agencies we expect the market to adopt a “shoot first, ask questions later” stance. This implies that UK government bonds are likely to suffer from the current move into uncharted territory and the potentially negative consequences for the UK’s current account and government balance.

Figure 7: UK’s sovereign CDS has widened since January
Figure 7: UK’s sovereign CDS has widened since JanuarySource: Macrobond
Figure 8: Corporate credit spreads 10y (over UK Gilts)
Figure 8: Corporate credit spreads 10y (over UK Gilts)Source: Macrobond

Q11. What will be the impact on UK long-term rates and credit spreads?

UK long-term benchmark interest rates (government bond yields and swaps) are expected to decline due to elevated risk-aversion and the expectation of lower investment and economic growth. Whilst concerns about the UK’s sovereign rating and the potential impact of Brexit on government finances could raise default risk premiums (reflected in higher CDS levels), this is likely to be outstripped by lower interest rate expectations (see also Q6) and safe-haven flows. Hence, state-swap spreads will widen in this case, also because we might see a rise in counterparty risk premiums.

More generally, we expect risk premiums to increase due to heightened and prolonged uncertainty. This implies that the cost and availability of financing for a broad range of UK borrowers could actually increase. A 50-150bp increase in average credit spreads (with lower rating classes seeing more significant widening) would appear possible, although there are several reasons to expect any moves to be contained by

- the fact that actual ‘Brexit’ is still relatively far away
- countervailing measures by the BoE, both in terms of liquidity and (possibly) new asset purchases if deemed necessary.

By the same token, we would see core Eurozone yields rally and curves flatten bullishly on the back of safe-haven flows – in particular when European leaders are in for a messy divorce (see also Q3). In that case, we would also peripheral spreads widening, and possibly even worryingly so when the coherence of the rest of the European Union – and the Eurozone – is at stake.

Q12. What about corporate credit spreads?

We are likely to see some spill-over effects on European credit spreads. However, with the ECB having just started its CSPP and in the absence of any immediate economic effects on the Eurozone, we would expect these spill-over effects to be relatively modest. This could change when countries start talking about holding a referendum of their own. In that case, lower-rated names (e.g. sub investment grade) in those countries are vulnerable, particularly those with a limited product line and exports to the ‘remaining’ EU countries.  It is also likely to be determined by sector and the issuer’s activities. In contrast, well diversified corporates, with solid credit ratings should weather the turbulence well and may even benefit from a ‘safe haven’ status. 

That said, the scenario where yesterday’s referendum outcome unleashes a broad-based global sell-off in financial markets is not to be excluded, in our view. This strongly rests on our view that the current state of markets (with elevated valuations) has been driven by monetary policy, which has lost its potency.

Disclaimer

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Author(s)
Elwin de Groot
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 69012
Stefan Koopman
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 69720
Carlijn Prins
RaboResearch Netherlands Rabobank KEO
+31 30 21 60033

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