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Four weeks ago, we discussed the bookmakers’ odds around the EU referendum and the disconnect between the odds and financial markets on the one hand and the polls on the other, suggesting that ‘either the FX market as a whole does not really believe the latest poll, or there are some participants out there with a great deal of firepower who are highly confident of a Remain vote.’
With the benefit of hindsight, it was probably a bit of both. Cash-rich Remain voters seem to have piled in with big bets, forcing the odds on Remain ever shorter; meanwhile, the bookies balanced their books by pushing the odds against Leave ever longer. This might all have been a bit of harmless fun had the financial markets during the week before the vote not taken a lead from the betting markets and wrongly assumed that Remain was a shoo-in. The result of this misplaced confidence was a roaring sterling rally, with GBP/USD putting on over 7% - moving from a low of 1.4013 on the 16th of July to a high of 1.5018 shortly after polls closed on the night of the 23rd.The FTSE 100 and 250 indices also soared, rallying 8.4% and 8.1% respectively. The similarity in the performance of the two indices ahead of the vote is fascinating, given their starkly different fates in the immediate aftermath.
On Friday 24th July, Britons emerged bleary-eyed in a state of shock. Even Nigel Farage (who resigned as leader of Ukip only this morning) had said that, after the two day moratorium on campaigning following the tragic murder of Jo Cox, Leave had lost momentum, and he no longer expected to win. Traders, fully set up for a Remain victory, hit the pound even harder than they (or, in a few cases, their parents) had in 1992. By 5am, GBP/USD had been pushed down to 1.3229 – 11.9% lower than the 2016 high set only six and a half hours earlier. The stock markets, of course were also sold off, with the FTSE 100 and 250 both down about 9%.
After a brief bounce up to 1.3900, sterling succumbed again to selling pressure and its chart has now formed the dreaded ‘L-shaped’ recovery, trading at the time of writing at 1.3256. Not so, however, the FTSE 100. This has now soared to 6579, 3.8% above its close on the 23rd. The oft-repeated reason for this is that around 70% of FTSE 100 revenues are earned overseas and are now worth more in sterling terms. The FTSE 250, which is much more domestically focussed, did not bottom out until the 27th of June and remains some 6.6% below its pre-Brexit close. There is an inconsistency here in the reactions of markets that were apparently prepared to ignore the impact of the surging pound whilst buying into the FTSE 100 before the vote, but afterwards used sterling’s lower level as an excuse for a higher valuation of the main index.
There are a couple of possible explanations. After the initial shock, investors may have re-rated the FTSE 100’s potential outside the EU. Stranger things have happened but this seems unlikely. More likely by far is that, ahead of the vote, underweight and short positions got squeezed out and traders were so desperate to buy that they simply ignored the currency effect on the FTSE 100.
While the FX and stock markets bounced around like things possessed, the gilt market simply rallied, marking the 10 year yield down from 1.37% to 1.05% on the 24th before pausing for breath. There was, however no real correction in yields, which continued to decline until last Friday, when the 10 year eventually bounced off an all-time low of 0.78%. The UK may have the worst current account deficit in history and a fiscal deficit which may now become even more difficult to control; however, for the time being at least, gilt investors are holding their nerve. That said, financial institutions and pension funds have little choice and the threat of a foreign buyers’ strike may be overstated: total UK National Debt is around £1.45 trillion and, of that, only 30% is held by overseas investors. The £435 billion that this represents could easily be mopped up by the Bank of England in an emergency.
The short end of the curve has also shifted sharply downwards, with the market now almost fully factoring in a 25 basis point cut by September. Mark Carney stands ready to act but a base rate cut seems unnecessary – or even dangerous. A cut to zero or negative 0.25% would provide little in the way of additional stimulus (we are back to Keynes’ old analogy of ‘pushing on a string’). Furthermore, as has been painfully evident in the eurozone, while very low rates hurt banks’ profits, negative ones are the kiss of death, owing to the difficulty of passing them on to customers. Additionally, there is the potential impact on confidence. If one is trying to instil an air of stability, a rate cut runs the risk of demonstrating just the opposite. Better by far simply to let the pound take the strain, as it has been doing. The 10% fall in sterling’s trade weighted index since the referendum is already worth about eight 0.25% base rate cuts: a change to official rates would be entirely superfluous.
Last week was not just shocking from a market perspective but also from a political one. In a day (Thursday), we moved from the consensus view (though everyone is probably now more cautious of consensi than ever!) that Boris Johnson would become PM and hold a snap election in the autumn, to the latest situation where Theresa May will apparently reunite the Conservative Party and proceed without an election. The first round of voting by Tory MPs for the leadership is tomorrow, with subsequent rounds whittling the current five candidates down to two by no later than next Tuesday. As a ‘reluctant Remainer’, May favours a ‘Brexit-lite’ approach but she needs to be elected first and the new PM will not be announced until the 9th of September.
This week will be dominated by the Tory leadership contest and its implications for Britain’s ongoing relationship with Europe. Unless the data are very weak, UK services PMI for June (tomorrow), together with industrial production and manufacturing output for May (Thursday), are unlikely to move the markets much as the numbers will only reflect the possibility, rather than the fact of, Brexit. The potential market mover, as ever, will be the US June non-farm payrolls data on Friday. An increase of 180,000 is expected after May’s very disappointing rise of just 38,000 – with unemployment expected up a notch to 4.8%. The data would need to be very strong indeed to cause the market to begin factoring in a rate rise before the US election in November. Indeed, the current expectation of a hike before then is close to zero.
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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