TWN Info Service on Finance and Development (Oct16/02)
7 October 2016
Third World Network

Markets recover from Brexit vote, soothed by central banks' response
Published in SUNS #8323 dated 30 September 2016

Geneva, 29 Sep (Kanaga Raja) -- Although the outcome of the United Kingdom's referendum on European Union membership (Brexit) came as a surprise to many observers and caused a stir in the markets during a few trading days, its impact soon subsided. The response of central banks, and the perception of investors that an extended period of easy monetary policy would still lie ahead, have appeared to play a soothing role.

This is the assessment of the Bank for International Settlements (BIS) on the Brexit vote in its latest Quarterly Review of September 2016.

The Basel-based central bank for the world's central banks said that central banks reasserted their sway over financial markets in recent months, after two quarters punctuated by bouts of sharp volatility.

"Markets proved resilient to a number of potentially disruptive political developments. Nevertheless, questions lingered as to whether the configuration of asset prices accurately reflected the underlying risks."

With global growth showing moderate but persistent signs of strengthening and supportive monetary policy, investors' risk appetite seemed to return during the period under review.

As a result, volatility in financial markets subsided, commodity prices edged higher, corporate credit spreads narrowed, stock markets rallied and portfolio flows to emerging market economies (EMEs) resumed.

At the same time, said BIS, yields in core fixed income markets plumbed new depths, and the pool of government debt trading at negative yields grew further to briefly exceed $10 trillion in July.

"As the summer went on, negative yields percolated to the high-grade corporate bond market, particularly in the euro area. The apparent dissonance between record low bond yields, on the one hand, and sharply higher stock prices with subdued volatility, on the other, cast a pall over such valuations. Banks' depressed equity prices and budding signs of tension in bank funding markets added another sobering note."

According to BIS, the outcome of the United Kingdom's referendum on European Union membership took many observers by surprise and caused a stir during a few trading days. But its impact soon subsided.

"Central banks' response, and investors' perception that an extended period of easy monetary policy would still lie ahead, appeared to play a soothing role."

The week preceding the 23 June referendum on the United Kingdom's membership in the European Union saw a wave of optimism that drove asset prices higher. UK and continental European stocks recorded large gains during that week, but valuations rallied across many jurisdictions.

Corporate spreads tightened (especially in the high-yield space) and sterling appreciated 5% against the US dollar, briefly touching its high for the year.

The outcome of the vote took markets by surprise, triggering a swift repricing. Within the two trading days that followed, major stock indices in advanced economies (AEs) plummeted more than 5%, with the FTSE 250 shedding almost 15%.

During the same time period, sterling nosedived by 10% and the US dollar appreciated across the board, except against the yen. Term spreads flattened in core bond markets with the 10-year-one-year gilt spread dropping almost 20 basis points.

Corporate high-yield spreads in the United States and the euro area widened by about 70 basis points, and investment grade spreads increased more than they had fallen the week before. EME benchmarks recorded more moderate swings, but followed basically the same path.

"Despite the sharpness of the initial reaction, market conditions remained orderly, trading volume was high and valuations soon recovered. Central banks promptly announced their readiness to provide liquidity and ensure the proper functioning of markets," said BIS.

Sentiment turned around the following week, and by mid-July, most asset classes had surpassed their 23 June closing prices. Even the FTSE 100, which includes UK companies with the largest exposure to foreign demand, closed 5% above its pre-referendum levels, buoyed by sterling's persistent depreciation. That said, assets more closely related to the United Kingdom and Europe remained weaker.

The Brexit vote triggered a broad-based reassessment of the future path of monetary policy globally. With improving headline growth still perceived as fragile in most AEs, and inflation persistently low, the additional uncertainty created by Brexit was seen as eliciting a distinct response from major central banks: policy rates would stay "lower for longer".

In the aftermath of the vote, markets expected the Bank of England to keep the policy rate unchanged at least through December 2017.

However, on 4 August the central bank cut the policy rate by 25 basis points (it is now 0.25%), and expanded the government bond purchase scheme by 60 billion pounds sterling, bringing the total to 435 billion pounds sterling.

It also established a new corporate bond purchase programme of 10 billion pounds sterling, and launched a new Term Funding Scheme that will provide funding for banks at rates close to the monetary policy rate.

Forward interest rates for December 2017 quickly dropped to the new level of the policy rate, reflecting the view that a quick policy reversal was not expected.

Immediately after the vote, financial markets anticipated that the Federal Reserve would push the resumption of its hiking cycle further into the future.

Questions about the path of policy rates were compounded by the ongoing debate among economists about the apparent decline in the neutral interest rate in the United States and elsewhere.

Given these short- and long-term considerations, the path towards "normalisation" looked more protracted and shallower than anticipated.

According to the BIS report, in late July, on strong data releases about the US economy, markets adjusted their expectations about the timing of future rises in the federal funds rate, but forward interest rates still pointed towards at most one increase through the end of 2017.

In the euro area and Japan, Brexit featured prominently among the risks to the economic outlook cited by central banks. On 21 July, the ECB reaffirmed its expectation that its key interest rates would stay at current or lower levels for an extended period of time, and well past the horizon of the asset purchase programme.

Moreover, the bank stressed that this programme, provisionally scheduled to end in March 2017, could be extended until the Governing Council saw a sustained adjustment in the inflation path consistent with its target.

On 29 July, the Bank of Japan announced extensions to its outstanding qualitative and quantitative easing (QQE) programme: it doubled the yearly pace of acquisition of exchange-traded funds (ETFs) to 6 trillion yen - equivalent to almost 8% of its flagship Japanese government bond (JGB) purchasing programme.

"During the period under review, the scope of expected monetary policy divergence between the United States, on the one hand, and the euro area and Japan, on the other, did not change much in markets' view.

Against this backdrop, the US dollar traded sideways against the euro and yen, and in fact most other currencies, after the initial reaction to Brexit."

The main outlier was sterling, which depreciated sharply after the referendum, while investors priced in a wider medium-term policy divergence between the United Kingdom and the United States.

"Central banks in other jurisdictions also followed an easing path. Most policy changes following the referendum resulted in an easing of policy, with Brexit or challenging global conditions often mentioned as the motivation. The only exceptions were some central banks in Latin America from large commodity producers, which increased rates in order to stabilise foreign exchange markets and contain inflationary pressures."

As the perception of reinforced monetary accommodation took hold, yields in core fixed income markets stayed under pressure. Conservative estimates of the amount of government bonds trading at negative yields surpassed $10 trillion within days after Brexit.

Negative yields gradually spread to investment grade corporate bonds in AEs. By late August, some market sources reckoned that up to 30% of the euro area high-grade corporate fixed income market was trading at negative yields.

In the gilt market, Bank of England purchases, combined with institutional investors' initial reluctance to sell, drove yields to their historical troughs. By early September, maturities close to 10 years had notched up capital gains of almost 6% since the referendum.

Some longer-dated gilts have seen price returns in excess of 20%. Thanks to capital gains from falling yields, returns in core fixed income markets this year have rivalled those of equity markets.

As a result, said BIS, core bond yields continued to probe historical lows. The near zero short-term interest rates in the United States and the United Kingdom represented post-Great Depression troughs, while short-term rates in Germany and Japan reached unprecedented negative levels over the summer.

The nominal yields of bonds with tenors close to 10 years were also at long-term lows in these countries as of the beginning of September.

In this context, some observers wondered whether core fixed income markets might be overvalued. These historically low bond yields have coincided with low estimated term premia.

"The compression of term premia appears to have accelerated after the adoption of negative interest rates, first in the euro area, then in Japan. This compression seems to have been exacerbated by Brexit."

Expectations of future interest rates have also played a role, said BIS, noting that as investors reassessed the likelihood for continued monetary accommodation in the largest currencies, nominal yields were pushed downwards.

"While this is especially true in the case of the United States, where a quicker expected pace of normalisation was partly reversed in early 2016, the expectations component played a smaller role in the euro area."

While yields in core fixed income markets were reaching record lows further out the maturity curve, which would normally be associated with expectations of subdued growth, stock markets and other market segments showed renewed ebullience, highlighting the sense of dissonance, said BIS.

Markets had already started a recovery, after a rocky start to the year. The turnaround can be dated to the weeks between the Bank of Japan's adoption of negative interest rates on 29 January and the ECB's announcement of additional expansion on 10 March.

"In July and August, as Brexit receded in the financial markets' rear-view mirror, exuberance resumed in full force. By mid-July, despite flagging earnings, stock markets in the US had broken through all-time highs."

Following a slump in the second quarter, equity prices in EMEs also bounced back and returned to levels last seen a year earlier. European and Japanese valuations were more tentative, as they wrestled with their own idiosyncratic uncertainties.

BIS noted that implied volatilities trended down towards, or below, post-crisis averages. Stock market volatility quickly approached the lows last seen in July 2014. Volatilities in other markets were less subdued, fluctuating around their recent averages and still far from 2014 depths.

"Brexit briefly boosted volatilities, but its impact was as transient as on prices. High valuations across most asset classes may have helped keep volatilities low."

As commodity prices recovered from their early 2016 lows, strong capital inflows to EMEs resumed. While commodity prices were still far from the high levels observed before mid-2014, the mild recovery helped to assuage concerns about the growth prospects for several large EMEs, especially in Latin America.

"More generally, there was an increasing perception that growth rates in EMEs had bottomed out," BIS underlined.

Conditions in private sector credit markets also eased significantly. Credit spreads in European and EME high- yield and investment grade corporates narrowed to levels not observed since early 2015. US corporate spreads fell proportionally less, possibly hampered by the large oil sector exposure and continued signs of a turn in the default cycle.

The Bank of Japan's decision in January to implement a negative interest rate appears to have been a key turning point in these markets. The persistent gap between credit spreads denominated in US dollars and euros was reinforced by changes to the ECB asset purchase programme.

This encouraged the issuance of euro-denominated debt by US companies, whose subsequent swapping into US dollars has contributed to a widening of the cross-currency basis since 2014, said BIS.

While equity markets in some jurisdictions were visiting new highs over the summer, banks' stocks headed down further and money markets displayed signs of tension, adding yet another dissonant note. Even though banks' debt-related instruments appeared to benefit from the global hunt for yield, their price-to-book ratios remained at the lower end of the post-Great Financial Crisis (GFC) range.

"Questions lingered about banks' ability to deliver adequate earnings in a context of compressed term premia and slow growth, especially in Japan and the euro area. Low and negative rates also presented banks with challenging trade-offs."

Expectations of sluggish AE growth and the uncertainty generated by the outcome of the UK referendum drove bank stocks down in June.

The rising uncertainty put the spotlight on persistent questions about the condition of banks in continental Europe, with the main German bank stocks suffering double-digit losses and stocks of Italian and Spanish banks sinking to new lows.

UK banks were also hit, as the outlook for the domestic economy worsened and a rethinking of business models became more pressing.

The main UK lenders recorded sizeable stock price drops following the referendum results, in most cases in excess of 15%.

After this initial phase, however, bank equity valuations rebounded to different degrees across countries. The stimulus package announced by the Bank of England on 4 August allowed UK bank stocks to regain some ground, though they still traded at a fraction of their book value.

Overall, the fall in the main UK and US bank equity indices proved to be short-lived, and stock prices soon reverted to their pre-referendum levels.

By contrast, the EURO STOXX Banks index was slower in regaining momentum. In early September stocks of euro area lenders were trading at less than 50% of their book values, pointing to increasing concerns about their ability to generate profits in a low-rate, low-growth environment.

"While the increase in implied volatilities in the aftermath of the referendum was moderate, policy uncertainty in Europe became quite high."

The results of the 2016 European Banking Authority (EBA) stress tests, released on 29 July, failed to reassure equity investors. The EBA found that only one (Monte dei Paschi di Siena) of the 51 banks under examination would default in the hypothesised adverse scenario.

However, the published results implied that five banks would fall short of the Basel III 7% Common Equity Tier 1 (CET1) requirement and two thirds of the banks would end up with a CET1 ratio below 10%.

However, BIS said that the release of the stress test results did not have a long-lasting impact on markets, as the outcomes were, in most cases, aligned with investors' initial expectations. Bank stocks fell sharply when the results were released, but soon rebounded to pre-stress test levels.

By comparison, previous tests had sometimes had a more sizeable and long-lasting effect on market valuations, whether positive (as in the case of the 2010 exercise) or negative.

Difficulties in Europe were mirrored by challenges in the Japanese banking sector. In an effort to improve profitability, the three main Japanese banks sold a large quantity of government bonds in the second quarter, more than doubling net trading income with respect to the same period of the previous year.

"However, the negative rate environment and protracted low economic growth continued to erode banks' earnings, pushing equity valuations to new lows."

Positive results from US banks accentuated the divide with Europe and Japan. Earnings for the six largest US banks met or beat expectations in the second quarter, while most of the industry fared well in the Fed's stress tests, with the exception of the subsidiaries of two European banks. Net interest margins have remained substantially flat since the December rate increase by the Fed.

Recent strains in money markets added to this overall adverse landscape. The three-month US dollar Libor-OIS spread soared from 25 to about 40 basis points from early July to the end of August.

In the past, spikes in this gauge have been associated with concerns about counter-party credit risk, particularly during the GFC and the subsequent sovereign debt crisis in Europe.

This time around, the increase seems to be mainly related to regulatory reforms designed to improve the resilience of the US money market fund (MMF) sector.

In particular, starting on 14 October 2016, new rules will require prime MMFs (which invest in non-government assets) and tax-exempt institutional funds to adopt a floating net asset value structure. Moreover, they will be allowed to impose redemption gates and liquidity fees in the event of a large increase in outflows.

In anticipation of these rules, investments have been shifting away from prime funds towards government funds since late 2015.

Since late June, this has resulted in nearly $250 billion in outflows from prime funds and more than $300 billion in inflows into government funds.

"This has created incipient funding tensions for non-US, especially Japanese, banks which rely heavily on prime funds for their US dollar funding. In turn, these developments have created additional funding demand in the dollar/yen cross-currency swap market, widening pre-existing anomalies in the basis," said BIS. +