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Friday, June 24, 2016

Brexit: What Does It Mean for the Bond Market?

Brexit: What Does It Mean for the Bond Market?

Key Points

  • Britain's vote to leave the European Union has pushed down U.S. Treasury yields, as risk-averse investors have flocked to the perceived safety of U.S. government bonds.
  • The Federal Reserve is now less likely to raise U.S. interest rates this year, and could even move for a rate cut.
  • Market turmoil underscores the importance of high-quality bonds as the core of a portfolio.
On Thursday, the British electorate voted to leave the European Union, ending 43 years of participation. It was a surprise. The market had been persuaded by early polls that voters would choose to stay in the EU for economic reasons. But anti-EU sentiment in northern England and elsewhere outside London proved too strong, as voters used the referendum to express their anxiety about the effects of globalization, immigration and regulation on industry. Prime Minister David Cameron has already announced he will step down. Once the prime minister has invoked Article 50 of the Lisbon Treaty, there will be a window of two years to negotiate the exit and Britain’s future relationship with the EU.

So far, here's what we're seeing as markets absorb the news:
  • U.S. Treasury yields are down as risk-averse investors have flocked to the perceived safety of U.S. government bonds. The 10-year yield is close to its 2012 low and the 30-year is back to the 1954 low of 2.37%. The market will probably scale back its expectations of a federal funds rate hike this year, and possibly build in expectations for a rate cut later in the year. I think a rate cut remains a very low probability, but the market will probably discount the possibility.
     
  • Risk aversion has also driven investors to German bunds and Japanese bonds, which have seen their prices rise. Yields—which move inversely to prices—are well into negative territory stretching out to 10-year maturities. However, peripheral European bond spreads are widening because of concerns that other countries, such as Spain and Portugal, could choose to leave the EU.
     
  • Credit spreads in the U.S. will probably widen. Based on credit default swap levels, it looks like energy and financials will be the hardest hit. The sharp rise in the U.S. dollar has sent commodity prices lower, while the financial sector has been hit because it is Britain’s largest industry. Some British-based banks may decide to leave the U.K. and set up headquarters inside an EU country. Some of the weakness in the financial sector will probably spread to U.S. financials. Preferred securities are vulnerable to a selloff due to the weakness in financials.
     
  • We don't believe this will lead to financial crisis similar to the one that followed the Lehman Brothers default in 2008. Banks are well capitalized and central banks are providing ample liquidity. However, it is negative for global growth, which is already very soft. Global trade is growing by less than 3% year over year—that is less than half the historical pace. The leave vote raises impediments to the free flow of goods, services and people, and that is bad for trade. Hence, it could slow the global economy further.

What investors should know

All in all, we're likely to see some volatility ahead. Here are a few things to keep in mind:
  • Situations like this are why it's important to hold high-quality bonds as the core of a portfolio. Unexpected events can happen, and high-quality bonds provide the ballast for a portfolio that allows you to ride out the ups and downs of the stock market.
     
  • Riskier parts of the bond market, such as high-yield and international bonds, are vulnerable because they are highly correlated with equities. That's why we suggest limiting your exposure to those asset classes.
     
  • We remain cautious about non-U.S.-dollar denominated bonds. Investors were facing a diminishing risk/reward outlook for their international bond investments even before the Brexit vote, due to factors including negative-interest-rate policies in various countries. This new shock will not improve the situation.

Next Steps

• Follow Kathy Jones on Twitter: @kathyjones

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