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Brexit plays on the minds of the central banks

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3 rd June 2015
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So it appears that the UK is a powerful nation with true global influence, at least to the US Federal Reserve and the European Central Bank (ECB). Whilst the topic of the EU referendum in the UK is not a thrilling topic, especially for those of us sitting in the middle of what is becoming a somewhat vacuous debate, it has become an issue of global significance. The Fed meets on the 15th June, one week before the referendum, and already they are managing expectations around the potential for a rate rise. Jerome Powell, a committee member, stated that the vote is a reason for “concern.” Dennis Lockhart, head of the Federal Reserve Bank of Atlanta, commented in May that Brexit is a “real concern.” The issue is not the single event of the UK leaving the EU, it is the far larger potential for political contagion across the continent. The prospect of the collapse of the euro as a currency, and potentially the entire EU as an entity, are matters that are focusing the mind of the Fed’s decision makers.

The Federal Reserve uses three tests to assess whether to change rates: improvement in the data from the previous quarter, employment numbers remaining strong, and inflation being on track (towards 2% target). Based on these tests there would be a strong case for a rate rise in June; however, with significant uncertainty around Brexit, this may be on pause until the July meeting. Janet Yellen has a speech on 6th June in Philadelphia which should be a good indicator of US intentions.

Moving back into Europe - the differing speeds of the eurozone economy are clear to see, with Spanish 10 year bonds trading at 1.53% on the back of its recent auction. Subscriber cover has also fallen from 4.33 times cover from the previous auction, to 1.53 times cover now. 10 year Italian bonds trade at 1.43% with German bunds trading at 0.15%. Such a wide spread between just these three countries demonstrates the clear stress some economies in Europe are under, and is reflected in the Fed’s thinking as well as the ECB.

The ECB met on Thursday, with the outcome that no further stimulus was offered, the refinancing rate remained at 0.0%, and the deposit rate at negative 0.4%. Draghi made it clear that there is more stimulus available as the ECB has more firepower; however, politicians have to pull their weight before he’ll act again. Reform is needed to ensure the actions of the ECB have the desired impact. His view is supported by a report by the Organisation for Economic Cooperation and Development (OECD), which criticised rich-world nations for failing to reform their economies and overburdening central banks. This is a sentiment supported by the International Monetary Fund (IMF). Prior to the meeting the ECB had already announced plans to launch a study into the impact of reform sluggishness on inflation. Draghi was specific on the areas where governments should be focusing, citing “actions to raise productivity and improve the business environment, including the provision of an adequate public infrastructure [in order to boost jobs and increase investment]”.

With the headlines being stolen by the UK, a small maritime nation on the northern fringes of the EU, another proud seafaring nation on the southern fringes continues to struggle. Greece will be hoping that Draghi soon restores the waiver on Greek collateral, which it was hoped would be announced at the press conference subsequent to the ECB meeting – it wasn’t. The waiver will enable Greek banks to move from Emergency Liquidity Assistance to regular ECB refinancing lines. The waiver was removed to encourage the reforms and conditions that were associated with the bail out last year. It is believed that the waiver is close to being reinstated and will be announced in the next month.

Although the tone of Draghi’s presentation was generally positive, including the announcements that the bank’s outlook on Gross Domestic Product (GDP) growth for 2016 has been increased to 1.6%, with Harmonised Index of Consumer Prices (HICP) outlook also revised upwards. The currency markets didn’t react positively, with the euro losing three tenths of a cent against both Sterling and the Dollar. The 10 year euro swap rate, which had been on the rise during the morning (peaking at 0.57%), fell on Draghi’s remarks, settling back at 0.535% - which is where it had started out the day.

The diversity in the world’s developed economies could not be starker than it is currently, with the Fed on the verge of further rate rises and the ECB trying to convince markets that everything is under control. However, for the next month the power lies in the hands of the UK voters, with both the Fed and ECB stating that the outcome will determine (or alter) their actions. The bookies have it that the Remain campaign will prevail (80%), but opinion polls show a small lead for the Leave campaign. There is still a way to go before things become clear.

All views expressed here are the author's own and are based on information and data available at the time of writing. 

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