Global Daily – Is Brexit a global risk?

by: Nick Kounis , Kim Liu , Roy Teo , Georgette Boele , Maritza Cabezas

 

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Global Markets – Equity markets were a sea of red on Tuesday, continuing the trend seen over recent days. Safe-haven demand was a strong driver of bond and currency markets – see below. The rising risk of Brexit appears to be a key determinant of the deterioration in investor sentiment. For instance, the VIX has jumped in recent days in sync with the probability of Brexit as judged by bookmakers. This raises the question whether this is justified. The direct effects of Brexit would be severe but would mainly fall on the UK economy, which is not big enough to destabilise global growth and markets. However, worries seem more justifiable from the perspective of the indirect effects on the rest of Europe. If Brexit fans anti-EU movements in other countries raising the risk of EU/euro fragmentation, then Brexit does constitute a more global risk. The selloff in peripheral government bonds over this period seems to fit this explanation, as does the general poor performance of the euro and eurozone equities in this environment. (Nick Kounis)

 

Government bonds – Fuelled by growing anxiety of a possible Brexit, 10y Bund yields dipped for the very first time into negative territory yesterday. Yields of government bonds have fallen sharply in recent weeks and on Monday 10y Bunds already tested the 0% threshold. However, yesterday’s news that more polls were showing a rise in favour of the Leave camp and the deterioration in risk appetite gave Bunds the final push. As a result, around 75% of German government bonds with a maturity between 2 and 30 years are trading at a negative yield. Around 40% of German sovereign bonds are trading below the ECB deposit rate facility of -40bps, which makes them ineligible for QE purchases. This will increase further speculation whether the ECB will have enough bonds to buy up to the end of the QE programme. The implied scarcity of German bonds further pushes down yields, leading to a virtuous cycle for bonds. For the short term we expect yields to remain at extremely low levels, but we forecast 10y Bund yields to reach 0.20% at the end of the year as our base case is for no Brexit. (Kim Liu)

 

FX – Safe haven flows continued to support the Japanese yen and the Swiss franc. USD/JPY is testing this year’s low of 105.55 against the US dollar. In the past two weeks, the 2-week yen implied volatility has surged as investors hedge risks ahead of the UK referendum on the EU on 23 June and the BoJ monetary policy decision later this week. In our view the BoJ is likely to keep monetary policy unchanged on 16 June. If the BoJ fails to convince financial markets that they will do whatever it takes to inflate the economy in the next monetary policy meeting in July, further yen strength is expected to trigger stop losses layered below 105.  Overnight, stop losses in GBP/JPY and EUR/JPY were triggered after 150 and 120 respectively were breached. The risk of unilateral currency intervention by the Japan Ministry of Finance will increase as the yen strengthens towards 100 against the US dollar. Fears of a Brexit have also pushed the Swiss franc higher, though the SNB has been intervening to cap the upside.  It is likely that in case of a Brexit the SNB will even step up FX intervention. (Roy Teo & Georgette Boele)

 

Fed preview – There is no doubt that after May’s weak labour market report, the FOMC will stay on hold at today’s meeting. The meeting will be followed by a press conference in which we expect Chair Yellen to remain optimistic about the economic and labour market outlook, while taking a wait and see stance to see whether data improves and whether Brexit is avoided. This is in line with her most recent intervention made after the jobs report. In addition, we expect the FOMC statement to be adjusted to capture the weaker labour market conditions. The FOMC will also release its economic forecasts, which will likely show a slightly slower GDP growth outlook, while inflation will likely be a bit higher, but unemployment should be roughly unchanged. As for the dot plot, assessing the appropriate monetary policy, we think that the pace of rate hikes will be somewhat slower than previously estimated. We expect the Fed to refrain from hiking rate hikes this year, but there is still a possibility of one rate hike. (Maritza Cabezas)