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Macro Thoughts: Thanks a 1.27 million


Keith Grindlay of Macro Thoughts comments that as if 1.27 million more UK voters voting to leave Europe than to stay wasn’t shock enough, David Cameron has proven that UK unemployment would go higher with a vote to leave, by increasing unemployment by one, announcing his resignation as Prime Minister by October. 

This should send shock waves throughout Europe and European governments, further encouraging the growing movement in Europe for similar referenda. Over the next 18 months countries responsible for 90 per cent of Europe’s GDP will hold elections: Spain this weekend, Germany and France next year.  Japan will hold elections in July and the US Presidential elections are in November.  Between these events, China, with total Debt to GDP of around 250 per cent and having been snubbed again by the MCSI, will have to face up to record levels of bond repayments, leading to inevitable defaults.         
The high turn out of voters was the warning sign that the leave voters were out in force, yet markets were over optimistic. Polls suggested the vote was close, 52 per cent to 48 per cent, and once the result from Northampton was known, it started to become more apparent that the pollsters were right this time and the City had miscalculated. Scotland voted against leaving by 61 per cent, opening the debate for another independence vote.
Those who experienced the UK defending its position in the ERM on ‘Black Wednesday’ will have known it was time to be cautious, as they will have been reminded of interest rates jumping from 10 per cent to 15 per cent in a morning. Though such market moves are significant, much of the overoptimistic positioning that had built in markets needed to be unwound and central banks must not overreact. Even though the market adjustment was extreme to start with, there is not the same panic feel of 1992.
In Bond markets, the 10 year spread between Germany and Spain/Italy widened 50bp to 60bp, Bunds futures opened at an all time high, 168.50, 491 tics higher, but dropped 250 tics within hours, while BTP Futures opened 500tics lower and quickly rallied 400 tics. US Treasury yields fell from 1.6775 per cent to a low of 1.4750 per cent, the lowest level since 2012. Macro Thoughts’ initial target of 1.50 per cent set in its end of year review was reached and 1.35 per cent is expected before year end. TY1 (Treasury futures) volatility for the September contract rallied from the previous day’s close, 5.25 per cent, to 6.5 per cent and the spill over hit Swiss bonds as the SNB were forced to intervene in the currency markets.
The previous day’s strange optimism, that had pushed GBPUSD to 1.50, the highest level in six months, evaporated as the results began to feed through and it became clear the leave campaign had been more credible than markets had expected. Higher margin calls and stop-losses from the previous day’s over-optimism added to pressure on Cable, which fell over 10 per cent within 4 hours, to a low of 1.3230, before recovering to 1.3860. The Euro dropped from 1.1425 (again, an optimistic level) to 1.0915, before recovering, but the real surprise was the JPY, which dropped from 106.85 to as low as 99.02, below 100 for the first time since 2013.
To allow markets to trade Short Sterling, circuit breakers were moved from 20 to 60 ticks. As investment banks announce their belated changes to rate expectations from the Bank of England, markets moved to price up to 50bp more rate cuts than they had the previous day, yet the UK Gilt market was as calm as any. At the start of June, markets had priced 10year Gilts at 1.44 per cent and by June 16th this had dropped to 1.07 per cent, before recovering to 1.37 per cent the day before the vote. At the open, Gilts dropped that entire range to new all-time lows of 1.01 per cent.
Cameron’s resignation took away some uncertainty and Mark Carney’s speech immediately afterwards helped to calm markets by reminding that UK banks have GBP600 billion held in liquidity and the Bank of England is prepared to add a further GBP250 billion should it be needed.
Macro Thoughts felt that Gilt yields would hold 1 per cent. The risk for the UK is its high level of debt; the Current Account deficit is 7 per cent, Public sector debt 4 per cent and Household debt 2.4 per cent, and there is already talk of credit rating downgrades from S&P; therefore, despite investment banks forecasting 1 to 2 rate cuts, the reaction for Gilts is less certain. Any downgrade could lead to higher borrowing costs, putting pressure on Gilt yields, while the fall in Sterling should help compensate exporters, in a world that is looking to devalue.
Germany is the UK’s largest European trading partner in terms of goods, while the UK is Germany’s third largest, with Eur120 billion going to the UK (8 per cent of their exports).  The initial reaction for equities is to focus on German car and pharmaceutical companies, but there is a danger of overreaction. While there are expectations of rate cuts and downgrading UK equity and financial sectors, is foreign demand for UK property suddenly going to fall, given a discount from the drop in Sterling and without the fear of a transaction tax, could the City be in a better place? German unions have already given their support to the UK, whatever the result, and announcements from Deutsche Börse to buy the London Stock Exchange and Société Générale buying Kleinwort Benson prior to the Brexit vote would appear to be a vote of confidence in the UK economy.
Even so, equity markets were hit as hard as Bond and Forex markets, the CAC opening over 9.25 per cent down and Dax down by 8.5 per cent, but with European leaders pledging support and Merkel due to make a speech at 12.30CET, some calm has been achieved (prior to the US market opening).  The reaction from the US is likely to be as volatile as Europe’s, but the relative calm that has ensued should help, especially as the FTSE has been outperforming its peers.
Europe’s bluff has been called, yet Cameron has felt he needs to fall on his sword. By October, the UK will have a new PM, which won’t necessarily mean an immediate election. Gordon Brown set the precedent and Cameron had previously said this would be his last term. The person chosen by the Conservative party as the one to lead the negotiations for the brave, new Britain, will also be the person leading the party into the next general election.
Remain campaigners will now hope that negotiations under Article 50 of the Lisbon Treaty, which could take up to two years, won’t drag the UK too far away from Europe, but will force the EU to face up to the growing discontent that has been manifesting for years. This two year ‘cooling’ period should force the EU commission into change, though it would not be in its own interests to do so.
By the end of the year, the political and economic landscape will have changed and the ladies may be in charge, with Hilary, Angela and Theresa leading their countries, while another lady may be made redundant, as the Fed, which was already fighting a lost cause, may finally throw in the towel by ending any suggestion of a rate hike this year.
Keith Grindlay
Mobile 07787 508161
Disclaimer: Macro Thoughts are a commentary, not investment research or advice – they are for information only and should be regarded as unregulated by the Financial Conduct Authority. While several people have my agreement to forward Macro Thoughts, I would appreciate being contacted first.

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