Weak Economic Forecast Amid Brexit Uncertainty, Takes Its Toll On Pound And Bond Yields

  • Aug 01, 2019 BST
  • Team Kalkine
Weak Economic Forecast Amid Brexit Uncertainty, Takes Its Toll On Pound And Bond Yields

Amid buoyant equity market and historically low bond yields, many investors feel that the financial markets have not adjusted according to the predictions made by many experts about the state of the economy of the United Kingdom after Brexit. But there is hardly any doubt that the pound has aptly captured the mood of the market and has worked well as the barometer to weigh the sentiments of the market. If the fall of sterling gives any direction of sentiment, then there is no doubt in what investors have been thinking that the appeal of the British economy is set to decline after the country leaves the European Union, a long drawn and acrimonious divorce.

As a result of a rate cut by the Federal Reserve Bank and continued Brexit uncertainties, the British pound declined to a 30-month low against the US dollar on 1 August, as the currency was trading below 1.210 in mid-session. After a brief respite on 31 July, the currency resumed its downward trend that had largely started since the country decided to leave the European Union in 2016. The current downward rally started in March when the first deadline to exit the EU bloc was delayed after the transition deal brokered by former Prime Minister Theresa May was rejected by the parliament. The currency has continued its downtrend more vigorously since it became clear that Boris Johnson would become the next Prime Minister of the country.

Since Article 50, the official mechanism which started the Brexit process, was triggered by Mrs May on March 2017, the currency dropped below 1.23 against the US dollar for the first time on July 29, 2019, and it had fallen by around 4.7 per cent throughout July, as pressure on the currency came in the form of the new Prime Minister. Mr Johnson, a Brexiteer, had ascended to his current position on the promise to take the country out of the EU with or without a deal and has insisted that his administration is prepared to accept the expensive chaos of leaving the European Union without a transmission agreement in place. Since Mr Johnson took over Mrs May, the pound has lost approximately 3 per cent of its value against both the American dollar and the euro, as investors ready themselves ahead of a potential disaster, which possess the ability to derail the global economic growth.

Investors are now expecting that the Bank of England would cut interest rates by December, despite the threat of inflation, to spur the economy and prepare for the threat of no-deal Brexit and slowing global economy. A cut in interest rates would put more pressure on the currency, which seems to be short on positive developments these days. Moreover, as the EU leaders stuck to their position to continue with the terms agreed with the former prime minister, and the UK prime minister waits for the EU to reopen negotiations, the prospect of a no-deal exit has considerably increased, which might lead to the pound taking further beatings. While measures of implied volatility are rising amid the impasse between the two parties, currency options positioning indicates that the market is inclined towards a larger fall in the pound over the next 90 days and beyond. Since the financial crisis in 2008, implied volatility over a three-month period rose by the widest margin in July, and the price to hedge against large swings too has risen as the investors expect more volatility.

The recent decline in pound can also be attributed to the relative strengthening of the US dollar. On 31 July, the US central bank cut its policy rate by 25 basis point, the first cut in interest rates since 2008, in response to a slowdown in the major economies and a growing risk of higher import tariffs. However, as the Fed Chairman Jerome Powell said that the cut was not same as the start of a lengthy rate-cutting cycle, investors were disappointed by the less dovish stance as they were expecting the central bank to leave the door open for future cuts or even a 50 basis point cut, triggering a rebound in the dollar. Generally, a rate cut leads to the selling of the domestic currency, but markets had already priced in the 25 basis point cut, and the hawkish outlook of the bank threw them adrift. The chairman said that future decisions would be data-driven, and the economy was in a good place, reflected by the recent uptick in retail sales, the strength of the labour market and the overall resilience in the economy, though manufacturing was a little weak.

Experts point out that more speculative hedge funds and pension funds have recently increased their bets against the pound and some investors have started to warn that the pound could sink to $1, as the prospect of a deal with the EU appearing to fade. While there has been a consensus in the market that harder the Brexit, the further the pound must decline, but there is a good reason not to sell the pound too soon aggressively. The currency would get a reprieve from the current trend by a delay beyond the current deadline or an indication of renewed negotiations between the UK and EU. The possibility of this is high as many experts reckon that the parliament will force the prime minister into seeking another extension as a majority of British MPs have shown they are against leaving the block without a proper deal in place. But a failure to clear the impasse is likely to result in another general election, something many commentators believe to be the most logical way to get out of the mess.

In the US and Eurozone, where the bank has not been able to achieve its inflation target, a weaker currency might please policymakers, but the officials in the UK seem to be deriving no pleasure from the decline. While the currency is currently vulnerable, a deal with the EU would send it soaring and prove to be a turnaround point.

Bond Yields Touches Multi-Year Lows

As the threat of no-deal exit has risen, investors have been flocking to the relative security of government bonds, which has driven the yields to record lows. On 1 August 2019, the British 10-year bond (or gilt) yield had declined by around 6% to 0.58% by afternoon. This comes as the Bank of England cut its economic growth forecast for 2019 to 1.3% from 1.5%, spooking the investor sentiments, though it left the policy rate unchanged at 0.75%. The central bank said that the chance of the economy falling into a recession is now 33%, adding to the impact of Brexit-related uncertainty on business investment.

The sovereign bonds are considered to be amongst the safest financial assets available in the market as these are backed by the central government of the issuing country, which generally has little to zero chances of defaulting, especially of a developed country like the United Kingdom. It must be noted that bond yields and bond prices are inversely related, so as the demand for a bond increases, its yields decline. Yields on sovereign bonds act as a benchmark for a plethora of fixed income securities and a wide variety of other loans. As the risk of a slowdown or any adverse impact on the economy due to macroeconomic event increases, the investors seek the surety of sovereign bonds, driving up their prices and leading to a fall in yield.

As, investors are expecting a rate cut this year by the Bank of England, on 29 July 2019, the yields on 10-year sovereign bonds touched their lowest level since the results of the 2016 Brexit vote, declining by 5.5 basis points to 0.633 per cent, as the UK debt rallied. However, the yields have gone further down since as the risk of hard Brexit increases as the new prime minister Boris Johnson and his Brexit-focused government have hardened their stance on Brexit, forcing investors to seek refuge in haven assets. The new administration had been adamant in its demand that the European Union should scrap the Irish backstop plan and agree to negotiation of the previous withdrawal agreement agreed by Theresa May. However, the EU leaders seem to be in no hurry to give in to these demands and have reiterated that the agreement is not negotiable.

The recent decline in the yields has been driven by the increasing probability that the British central bank would be forced to cut rates over the next few months, with at least one cut by the end of the year. According to implied probability from swaps, the chances of a rate cut by the end of this year hit 55 per cent, which also leads to downward pressure on the 10-year bonds. Falling yields have also put pressure on the pound as the returns on pound-denominated assets fall when yields decline. While the possibility of an increase in inflation has increased, exacerbated by the fall in sterling, investors seem to be not pricing that, suggesting that the political risk currently overweighs the risk of inflation.

Now when the outcome of the Brexit saga is as unpredictable as the actions and views of Boris Johnson. It is possible that the parliament would initiate a no-confidence vote, leading to a new election, a revised deal is still on the cards, revocation or delay of Brexit deadline is possible, and the much-dreaded no-deal Brexit too cannot be denied.

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