United Kingdom Referendum Roils Markets by OFR
The vote in the United Kingdom (U.K.) to leave the European Union (EU) was the defining focus of financial markets in the second quarter. The unexpected outcome was a shock to market confidence. It introduced considerable uncertainty about the rules governing the United Kingdom’s financial and economic transactions with the outside world. Although the immediate market volatility has subsided, the policy uncertainty and the ultimate financial and political spillovers may last for months or years, leaving markets vulnerable to further confidence shocks.
Key developments in the second quarter of 2016
- The U.K. voted to leave the EU in a June 23 referendum. Although the referendum is non-binding, the U.K. government is expected to respect the result and formally move to exit the EU, commonly referred to as Brexit.
- Uncertainty remains about if, how, and when Brexit will be implemented. Its full effects on U.K. and European economies and financial systems will depend on those policy decisions, unfolding over the coming months and years.
- Global risk assets sold off sharply in response to the vote. The U.K. currency and European financial stocks were hit hardest and they remain much weaker than before the vote (see Figure 1). The flow of investments to safe havens pushed long-term interest rates to historic lows in the United States, U.K., and Germany in late June and early July. On net, U.S. risk assets have since rebounded sharply, and equities in Europe recovered more than half their declines.
- Expectations of policies aimed at countering any post-referendum fallout and at shoring up the Japanese economy provided strong support for risk assets in the past two weeks. The yen in particular has retraced all of its postreferendum safe-haven rally.
The U.K. referendum result was a shock to market confidence.
To markets’ surprise, the “leave” option won nearly 52 percent of the vote. Global equity prices fell sharply on the news. Safe-haven flows pushed U.S., U.K., and German long-term yields to historic lows.
The British pound fell to its lowest level in more than 30 years. Despite heavy trading and large price moves, global markets functioned largely without disruptions.
Banks and other financial institutions were very hard hit in the market sell-offs (see Figure 2). The United Kingdom’s FTSE 350 Banks Index declined 16 percent over two trading days. Some U.K. banks, such as Barclays, Lloyds, and the Royal Bank of Scotland, declined by as much as 30 percent. Stocks of other European financial firms also fell sharply, and their credit default swap (CDS) spreads rose (see Figure 3). U.S. bank stocks also fell sharply, though less than their European counterparts did. The S&P 500 financials index decreased 8 percent and the KBW bank index dropped 12 percent.
Secured funding rates in the United States increased before and after the referendum. The overnight Treasury General Collateral Funding (GCF) repo rate, an indicator of dealer funding, spiked to more than 85 basis points on the day after the referendum. That compared with 44 basis points at the end of May. The rate finished the quarter at just under 88 basis points (see Figure 4). GCF repo rates typically rise at the end of each quarter when large banks, which lend cash in the GCF repo market, reduce their lending activities around quarter-end reporting dates. However, the spike in June was larger than usual.
In the week after the referendum, global equities, bonds, and emerging market currencies mostly retraced losses sustained in the two trading days after the vote. Many investors were reportedly reassured by the absence of dislocations in major markets or financial institutions after the vote, and by the willingness of the Bank of England and European Central Bank to provide liquidity support as needed. Still, some of the larger price moves persisted. The U.K. currency remained 10 percent weaker than before the vote. European financial stock prices remained much lower. German, U.S., and U.K. sovereign yields remained 20-to-50 basis points below pre-referendum levels.
The uncertainty may persist for months or years.
The unprecedented vote to exit the EU signals an extended period of uncertainty. Negotiations will not begin immediately. Once they do, the U.K. and EU have two years to negotiate an exit under the Lisbon Treaty, which sets the procedures. The time period can be extended only by a unanimous vote of EU members. The policy deliberations and negotiations may have far-reaching legal and economic implications for the large U.K. cross-border financial industry and for foreign investment in the U.K.
The vote has already led to political turmoil in the U.K. and affected the political landscape in other EU member countries. Uncertainty is expected to lead to slower growth as consumers and businesses in the U.K. and EU postpone spending and investment. After the vote, many economists lowered growth forecasts for the U.K. and broader EU. Some predicted a U.K. recession by early 2017. Economists surveyed by Bloomberg after the referendum estimated the probability of a U.K. recession over the next 12 months at about 71 percent, up from less than 20 percent before the vote.
In a severe scenario, shocks from the U.K. and Europe could affect U.S. growth and financial stability through trade linkages, large direct financial exposures, or confidence and indirect effects.
Brexit pushed interest rates to new historic lows.
The safe-haven flows after the referendum sent U.S., U.K., and German long-term interest rates to historic lows. Yields on these government bonds had been in decline well before Brexit (see Figure 5), and yields in much of Europe and Japan had been close to zero or negative. At the end of June, more than $9 trillion of sovereign debt globally was trading with negative yields, including about 40 percent of European government bonds and about 80 percent of Japanese government bonds. Negative interest rates in Europe and Japan are an intended outcome of quantitative easing programs and negative monetary policy rates (Figure 6). Spillovers from falling and negative interest rates in Europe have been key drivers of declining long-term U.S. interest rates, as discussed in the OFR’s 2015 Financial Stability Report. For more detail on market concerns about negative interest rates, see the Markets Monitor for the first quarter of 2016.
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