- Global central bank policy continues to be important for financial markets, but is running up against limits of potential effectiveness.
- We expect Brexit will be an economic challenge for the United Kingdom, but will have limited impact on the global economy and global interest rates.
- Among prevailing fixed-income market risks, we expect to emphasize our strategy of seeking attractive liquidity premiums across various sectors.
Although there were some important divergences in asset-class performance in the second quarter, the economy and financial markets remained dependent on accommodative monetary policy, even as doubts were growing about the effectiveness and sustainability of policy.
The Bank of Japan’s (BoJ’s) introduction of negative interest rates can hardly be counted a success; the European Central Bank’s expansion of its quantitative easing program has not yet had much of an impact on the eurozone outlook; there remain many concerns about Chinese economic policy; and U.S. financial markets have not been treating the Fed’s “dot plot” and announced preference for more hikes too seriously. In this context, Brexit can be seen as yet another example of things not working out the way global policymakers would like.
The limited impact of BrexitFor the most part, and most importantly, the U.K. referendum result is a shock to the United Kingdom — indeed, it is an important shock for an economy that was the fifth-largest economy in the world on June 22 and likely became the sixth-largest on June 23 (overtaken by France) due to the pound’s dramatic plunge. The United Kingdom is likely to fall into recession, and this will have some knock-on effect on the country’s trade partners. These direct effects are not large enough to be especially worrying to us. And yet, they may be quite long lasting because the outlook for the United Kingdom itself is quite uncertain now and the uncertainties will take some time to resolve.
We do not believe that Brexit is a Lehman-type shock to the world economy; there does not seem to be enough leverage in the global financial system to produce such an effect, and sterling is not important enough as a funding currency. We have seen a handful of funds that invest in U.K. commercial property halt redemptions, and this is an unwelcome echo of events in early 2008, even if it is so far contained.
The indirect effects are more worrying. First, Brexit underlines the world’s policy credibility problem. In our view, this will play out most acutely in Japan, where the yen has been rallying fairly steadily year to date, despite the manifest desire of the BoJ for a weaker currency. We believe Japan’s problems are worsening, and while the option of helicopter money remains available, we do not think it can be taken under current political circumstances. But as Japan continues on its course, it remains a large exporter of capital and a powerful force pushing down global interest rates. And this in turn allows the markets to disregard the U.S. Federal Reserve’s evident desire for higher rates in the United States.
Second, it has contributed to an exchange-rate shock. Sterling’s fall has of course pushed up other currencies; to the extent it has contributed to a “risk-off” trade, it has helped push up the U.S. dollar. This would normally tighten financial conditions in the United States. In these early post-Brexit weeks, this effect has been largely offset by the drop in Treasury yields.
Third, it poses a challenge for the European Union as it exacerbates the divisions between those who wish further integration and those who do not. We think it is unlikely that the region can emerge from this episode stronger economically. Moreover, it has turned markets’ attention back to the fragilities of the European banking system, and this is one channel through which concerns about “Europe” could grow. That said, we do not think any other countries are likely to follow the United Kingdom in holding referenda or in leaving the European Union, and so we do not think it likely that the European Union will, in any sense, “fall apart.” Indeed, opinion polls suggest a sharp rise in the popularity of the European Union in Germany and the Netherlands since the U.K. vote. But there will be a period of uncertainty.
What Brexit means for interest ratesPost-Brexit, the Fed is now on hold in terms of rate hikes. However, we do not think it is correct to see this as a fundamental change in strategy; rather, it is an acknowledgement that global uncertainties have risen. It is certainly possible that markets will calm down, the Brexit uncertainties will diminish, and the United States will look more secure on its course.
As San Francisco Fed President John Williams recently noted, if his forecast for the United States is right, then hikes will be warranted. The uncertainty is over whether the economy will actually remain on his forecast path. For this reason, we think it is fair to describe the Fed as wanting to hike, and likely to hike if the current uncertainties dissipate somewhat and the United States returns to a reasonable growth path. And in our view, the data do not need to be overwhelmingly strong to get the Fed to act.
The amount of time it will take to resolve the Brexit-related uncertainties and the lags in the data flow mean September is pretty much off the table for a rate hike, and it is hard to see that the data will be so clear that the Fed would feel comfortable moving in an election campaign. There is another point to consider in the light of the jobs report. The pace of job creation is easing; it is still well above the pace needed to accommodate the growth of the labor force, but it is easing. This suggests to us that, even if the Fed does manage to hike later this year, this hiking cycle will be over very soon.
Within the risk-averse environment toward the end of the second quarter, investors shifted capital away from riskier market sectors and into U.S. government bonds.