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