Trac­ing global mar­ket thread that could be un­rav­elled by Brexit

Pakistan Observer - - ECONOMY WATCH -

LONDON—If Bri­tons vote to take their coun­try out of the Euro­pean Union on June 23, no cor­ner of the global fi­nan­cial mar­ket com­plex will emerge un­scathed.

The in­vis­i­ble thread that links as­sets as di­verse as gold, bank stocks, the Ja­panese yen and gov­ern­ment bonds would be yanked sharply by Brexit, an event the Bank of Eng­land said on Thurs­day risks “ad­verse spillovers to the global econ­omy”.

With global in­ter­est rates and bond yields the low­est on record, cen­tral banks run­ning low on cri­sis-fight­ing tools and the post2008 eco­nomic re­cov­ery flag­ging, that thread could quickly un­ravel, with se­ri­ous con­se­quences for all mar­kets. So why will the will of one coun­try’s peo­ple in one ref­er­en­dum have such a pro­found impact on global mar­kets?

The an­swer is partly how in­ter­con­nected global mar­kets are, and partly tim­ing - the world eco­nomic cy­cle is al­ready very long in the tooth and cen­tral banks have far fewer op­tions open to them af­ter nearly a decade of ex­tra­or­di­nary pol­icy sup­port.

Global in­ter­est rates are their low­est for 5,000 years, ac­cord­ing to Bank of Amer­ica, but cen­tral banks could still cut them fur­ther. That could mean the U.S. Fed­eral Re­serve re­vers­ing its slow-start­ing tight­en­ing cy­cle, and Euro­pean Cen­tral Bank and Bank of Ja­pan rates go­ing deeper into neg­a­tive ter­ri­tory. Lower rates would also de­press bond yields even fur­ther, tight­en­ing the screw on cen­tral and com­mer­cial banks.

Over $8 tril­lion worth of sov­er­eign bonds al­ready carry a neg­a­tive yield, ac­cord­ing to JPMor­gan. This means hold­ers of Ja­panese, Ger­man and Swiss debt are pay­ing these gov­ern­ments for the priv­i­lege of lend­ing to them, in some cases out to 20 years.

They are will­ing to ac­cept they will not get all their money back. Even deeper neg­a­tive yields would in­crease these losses, rais­ing fur­ther doubt that these are truly “safe haven” as­sets.

But the im­me­di­ate eco­nomic and po­lit­i­cal un­cer­tainty af­ter a Brexit vote would likely be so great that de­mand for these bonds would rise any­way, pulling yields even lower. Yield curves, the dif­fer­ence be­tween short- and longer-dated bond bor­row­ing costs, would flat­ten fur­ther.

They are al­ready their flat­test for years around the de­vel­oped world, mean­ing the pre­mium in­vestors ex­pect for hold­ing longer­dated bonds is shrink­ing. This is of­ten an omi­nous sig­nal of low in­fla­tion or de­fla­tion, and slow­ing eco­nomic growth or pos­si­bly re­ces­sion.

If “core” bond yields would likely fall, yields on low­er­rated and riskier bonds would likely rise, widen­ing the spread be­tween the two. This would in­crease the fi­nanc­ing pres­sure on a wide range of companies around the world and gov­ern­ments in euro zone “pe­riph­ery” coun­tries like Greece, Italy and Spain.

Flat yield curves are bad news for banks, who make money from bor­row­ing short-term at low rates and lend­ing longer-term at higher rates. Fi­nan­cial stocks have been hit hard this year as the curve flat­ten­ing has ac­cel­er­ated.

Euro zone banks are down 30 per­cent this year, Ja­panese banks 35 per­cent, UK banks 20 per­cent, and U.S. banks 10 per­cent. Banks are also be­ing squeezed by neg­a­tive de­posit rates. The ECB, Bank of Ja­pan and Swiss Na­tional Bank all charge banks for de­posit­ing cash.

It may even be­come cheaper for banks to put bil­lions of yen, eu­ros or francs of their cus­tomers’ cash in vaults — a pos­si­bil­ity Ger­man lender Com­merzbank is ex­am­in­ing. As for cen­tral banks, any move deeper into the un­charted world of neg­a­tive in­ter­est rates would be taken re­luc­tantly.

In the case of the ECB, de­clin­ing yields would fur­ther cut the amount of bonds el­i­gi­ble for pur­chase as part of its quan­ti­ta­tive eas­ing stim­u­lus pro­gram. That would make its in­fla­tion tar­get of just un­der 2 per­cent much harder to achieve, in turn putting its cred­i­bil­ity un­der even greater scru­tiny.

Just as the 2007-08 fi­nan­cial cri­sis was caused by un­prece­dented stress in the bank­ing system, an­a­lysts fear Brexit fall­out could again threaten to block the global fi­nan­cial system’s plumb­ing.

Banks have re­cov­ered from 2007-08 but stresses are al­ready ap­pear­ing in more ob­scure pock­ets of dollar-based FX and rates mar­kets that are hit­ting lev­els more as­so­ci­ated with pe­ri­ods of cri­sis. The pre­mium for dol­lars over yen in the cross cur­rency ba­sis mar­ket is its high­est in years.

Spreads be­tween Li­bor rates and overnight in­dex swap (OIS) rates, broadly a mea­sure of in­vestors’ per­cep­tion of credit risk in the bank­ing system, are also widen­ing. In nor­mal con­di­tions, Li­bor/OIS spreads should be vir­tu­ally zero.—Reuters

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