For a number of years now, the bond market has been plagued regularly by worries that southern European countries would end up leaving the European Union, with concerns over such an exit leading to sharp rises in the yields on their government bonds. Over time, however, even the risk of a ‘Grexit’ has been neutralised, helped by the rise to power of an anti-austerity government in Greece which finally accepted the principles of the Maastricht treaty. Now we have Brexit.
A pro-Brexit vote was not something that the markets had anticipated. One of the most powerful countries in the EU, home to a financial centre that stigmatised ‘peripheral’ country risk, is the first to leave the union behind. The surprise vote to exit the EU was accompanied by a sharp fall in bond yields to historic lows for many European sovereign issuers! This democratic earthquake has triggered a period of deep political uncertainty, initially around the complex and lengthy exit negotiations, made all the more complicated by the fact that apparently, no British politician was really prepared for this outcome.
Protracted Brexit means lower rates for longer
As part of Brexit, negotiations are set to last at least two years under Article 50 of the Treaty of Lisbon. Among the first implications of the Brexit vote, many companies are likely to freeze their investments in the UK. This will last at least until the route ahead is clearer. The UK is then likely to experience a fall in property prices, with the likely departure of foreign residents.
Household consumption looks set to fall, with the depreciation of the pound driving up prices of imported consumer goods. Such a slowdown could impact economic conditions throughout Europe, where the recovery remains fragile, impairing risky assets. In response, we can expect the ECB to increase, but also extend in time, its ultra-loose monetary policy, driving yields lower and in turn supporting bond prices. Low rates are here to stay!
Written on 29 June 2016 for publication in Option Finance ©Option Finance