Brexit: Is It Moving Markets?

With the highly anticipated public referendum on Britain’s exit (“Brexit”) from the European Union E.U.) set for June 23, the topic has begun to percolate among bond traders and other market participants.

At the moment, it seems fair to say that markets are already pricing in a “Brexit discount,” resulting in higher currency volatility and higher interest rates. As we move toward the referendum date, it seems to us that headline risk is likely to weigh more on the pound sterling and less on the euro, largely because Britain’s economy is substantially smaller than that of the broader Union. By and large, during times of market anxiety, a smaller economy stands to see its currency affected to a higher degree than a larger economy would.

We are also keeping in mind the possibility that the Bank of England may need to provide monetary easing to reduce the risk of weaker growth and tightening credit conditions. What’s more, we recognize the possibility that a European equity-market selloff could unravel, largely due to uncertainty about economic growth and financial market stability as investors try to make sense of a potential painful fracture in the Union.

Clearly, this is not politics as usual

We believe the United Kingdom’s referendum has ramifications that stretch beyond typical policy concerns; indeed, as noted above, the referendum is casting a shadow over securities markets as well.

Here are some brief bullet points to help illustrate the interaction between political and market forces that will be on hand as the date approaches, all of which can potentially influence international bond markets.

• If polls begin trending toward Britain’s remaining in the E.U., they may reverse today’s pessimistic
markets. On the other hand, should the “leave” vote lead the polls, we believe securities
markets may overshoot to the downside (possibly presenting opportunities to capitalize on price
weakness).

• In the case of an eventual “leave” vote, the U.K. would need to unwind its integration into the Union, potentially ensnaring many administrative resources for a long time. The economic and financial interaction between the U.K. and other E.U. member states is significant. Consider that as of 2014, E.U. trade with Britain amounted to $601 billion, representing 21% of U.K. gross domestic product (GDP), while accounting for 12% of exports and 9% of imports. Direct investment into the U.K. from the E.U. was $982 billion, while $709 billion went from the U.K. to the E.U. Portfolio investment was $1.9 trillion into the U.K. and $1.5 trillion from the U.K. Population migration from the U.K. to the rest
of the E.U. was 133,500 (less than 0.2% of the U.K. population), while 222,800 migrants from E.U. member countries made their way to the U.K. in 2014.