In The Wake Of Brexit

| About: DB German (BUNL)

Summary

Borrowing costs across the euro-zone continue to rise as capital flows seek out safe harbor vehicles in the US, Germany and Japan.

The rally in treasury notes at the long end of the yield curve continue to surge pushing the yields of German and Japanese debt issues deeper into negative territory.

The Brexit vote is not a black swan event by early measures, but markets will continue to adjust to the new realities the vote created.

Market uncertainty and the mitigation of contagion will characterize the immediate post-Brexit era.

Michael Gove, a Conservative Member of Parliament, former education secretary and once close political confidant of now former Prime Minister David Cameron, blurted out an unscripted retort that resonated around the world on the eve of Brexit vote: "People in this country have had enough of experts." The referendum aptly captured the moment. The aftermath may not be as clear-cut.

After joining the European Union along with Denmark and Ireland in January 1973, Britons decided to end that formal relationship in an historic vote that captured the opinions of over 72% of eligible voters. Prime Minister David Cameron resigned with the announcement of the voting results early Friday morning and will head a caretaker government through October until his replacement can be selected. National elections will likely be called to establish a new governing mandate from voters as Britain picks up the pieces from this historic vote that could cost the country dearly in the months and years to come.

The forex markets have pretty much followed readily predictable patterns:

  • The pound fell to $1.36 against the dollar in early trading-its lowest post since September 1985;
  • Against the euro, the pound peaked at €1.50 in 2007 before tumbling to a low of €1.04 in 2009. Just prior to the vote, the pound hit a peak of €1.41 only to give up about 8% of its gains;
  • The yen soared to $102.37 against the dollar-its highest post since March of 2014;
  • The euro fell to $1.114 against the dollar and has traded in a relatively narrow range after closing yesterday at $1.14 on the eve of the Brexit vote;
  • The US Dollar Index (DXY) surged to an after-hours high of 96.42 before giving up some of its gains to settle at 95.29

Caught unawares, world exchanges plunged in heavy trading:

  • In Europe the downdraft ranges from a low on the Italian FTSE MIB of 11.13% to the UK FTSE 100's 2.35%;
  • In Asia the Hang Sen is down 2.92% while the Nikkei 225 is down 7.92%. The Shanghai Composite is down slightly at 1.30%
  • Ten-year treasury rally continues as institutional capital flows pile into US, Germany and Japan safe haven vehicles. Both German Bund and Japanese government bonds sank deeper into negative territory.

Broadly speaking, the biggest concern in the immediate term is uncertainty. Greece has come close to crashing out of the euro-zone on numerous occasions over the past several years. Athens is certainly not out of the woods on the score by any stretch. For Britain, no country has ever voluntarily withdrawn from either the euro-zone or EU in the history of either organizational format. Article 50 of the Lisbon Treaty offers up an outline of the process, but real-time give-and-take of the actual negotiation process is yet to be tested.

Yet none of the process will even begin to take form until a new prime minister is in place, presumably after a national election that will likely be scheduled for some time in the mid-winter months. The Brexit negotiations might not start in earnest until the beginning months of 2017. For her part, German Chancellor Angela Merkel has already publicly stated the desire to expedite the Article 50 process as quickly as possible. The EU institutional substructure, weak and underdeveloped at its best - has taken a broadside hit and the fallout from a UK withdrawal is extremely hard to project. Sorting out the sheer volume of issues related both to the UK withdrawal from - not to mention the future relations with - the EU will likely take years of tedious negotiations. The EU bailout negotiations with Greece began in April 2010 and are now in their third iteration - and far from complete. While the Article 50 process has a limit of two years with any extension of the process subject to a unanimous vote of member states, a protracted negotiation process is expected, a process that carries with it an enormous headwind for economic growth and political stability in both Britain as well as the EU.

Contagion is the next biggest concern. Euro-skepticism is by no means confined to Britain, and the example of Brexit has uncorked a pernicious genie on a rather fertile landscape. According to a recent Pew Research Report, there is widespread disapproval across the EU landscape in the handling of refugees, the economy and further European integration. Young people are more likely than older generations to have a favorable opinion on the EU - not dissimilar from the generational split amongst Britons in early research of polling data. Yet apart from the Northern tier EU countries, this same younger generation struggles mightily with some of the highest unemployment rates in the developed world. Copy-cat calls for referenda on the EU and even the euro are likely a defining feature of a new post-Brexit normal:

  • In 2014, Scotland narrowly voted to stay in the United Kingdom, a relationship that dates back to 1707 and the reign of Queen Anne. The vote to stay in the UK was largely predicated on the UK position in the EU. Now that the UK will have to negotiate both its withdrawal from and future relationship with the EU, Scottish voters will likely revisit the decision in the near future. The Scottish vote in the Brexit referendum came in at about 63% to remain in the EU;
  • Spain is now eyeing a referendum on Gibraltar - another British acquisition from the reign of Queen Anne in 1704;
  • The region of Catalan looks to regain its sovereignty from Spain;
  • Recent mayoral wins by the 5-Star Movement in Rome and Turin are now calling for an Italian referendum on the euro.

A similarly lopsided vote to remain in the EU came from British voters of Irish extraction in the UK, including Northern Ireland. In 2014 about 38% of all Irish goods came from the UK while about 15% of all Irish exports went to the UK according to Eurostat data. Northern Ireland has long had an open border with the Republic of Ireland, a member of both the EU and the euro-zone. The border between the two Irelands will now delineate the western frontier of the EU, presumably complete with border crossings and checkpoints. The flow of goods and services will likely morph from free to some form of tariff regime. The United Kingdom could easily become much less united in Brexit's wake.

The noisy and oftentimes acrimonious populist wave that played on the inchoate fears of many Britons will likely infect upcoming electoral cycles across the developed world. These base fears have been complicated by technological change, trade agreements, job loss, sclerotic economic and wage growth, growing income disparities, globalization, immigration - all issues that tipped the results in Britain - will certainly be replayed with added fervor by other anti-establishment parties across the Continent. The Brexit vote can be expected to be an important rallying call in national elections scheduled for next year in France and Germany - not to mention here in the United States come November. Capital markets will respond by mitigating risk at every possible turn. Economic growth, already anemic across the EU even before the British vote, is likely to chart new depths of mediocrity.

Figure 1: 10-year Treasury Notes and Resulting Spreads (basis points)

Country

Current (24 June)

1 Month

Spread vs Germany (b/p)

Spread at 1 Month (b/p)

Germany

-0.057%

0.179%

Italy

1.492%

1.494%

1,549

1,315

Spain

1.637%

1.591%

1,694

1,412

Portugal

3.087%

3.079%

3,144

2,900

France

0.392%

0.521%

449

342

Netherlands

0.190%

0.268%

247

89

UK

1.087%

1.452%

1,144

973

US

1.575%

1.836%

1,632

1,657

Click to enlarge

Borrowing costs - the Achilles' heel of the EU - are now on the rise as institutional capital flows pour into the traditional safe haven vehicles housed in the US, Germany and Japan, and the redirection of investment funds is likely in for a long and protracted run (see Figure 1, above). For Britain and the EU, the path toward a new relationship is simply unknown - but almost guaranteed to be more expensive. Almost half of British exports in both goods and services cross the Channel and are sold duty free in EU markets. That relationship will almost certainly change in the future. Just as the Brexit referendum captured the sour mood of Britons, so too will the negotiation process capture an equally sour mood of a jilted EU. A duty-free, Swiss-like trade deal for Britain the possibility of which was often mentioned during the campaign, will likely not result in the current environment. Discouraging other malcontents across the EU landscape from pursuing a similar path will likely be a high priority of EU negotiators.

Forging hard and fast comparisons across national borders is always problematic. Switzerland is a small, landlocked alpine country of 8 million people - about an eighth the size of Britain with about twice the income per capita. Switzerland's economic structure is highly productive with a large percentage of its overall output centered on providing an array of financial services to the world's wealthy, not unlike London's financial district. While providing a modicum of comparative value complete with some of the world's most lucrative pay packets and most expensive real estate valuations, Britain's economy beyond London's environs morphs quickly into more traditional modes of private and public sector production - all with varying levels of efficiency, scale and productivity.

The bigger issue, however, is the free movement of people across national borders of the euro-area captured by the Schengen Agreement (1985), signed in the waning years of the Cold War. With Europe divided both politically and militarily east to west, the concept of visa-free movement of people across national borders offered up a glaring contrast between a democratic Western Europe and a Soviet dominated Eastern Europe. While the fall of the Berlin Wall in 1989 and the implosion of the Soviet Union in 1991 usurped much of this cold war political dimension, the Schengen Agreement has now taken a debilitating turn in the wake of refugees fleeing the ravages of war in Syria and beyond. The human deluge is now the largest movement of people across European national borders since WWII. The resulting nativist response across much of the European political landscape arguably lies at the center of the Brexit decision. In 2014, the Swiss took direct aim at the Schengen Agreement by approving a measure to impose immigration quotas on EU countries, primarily to curb at the time the influx of East European workers seeking better economic opportunities in Europe. Brussels flatly rejected the quota mechanism set in place by the Swiss vote. Britain can expect a similar hard line.

The forex plays outlined by many in the weeks preceding the British Referendum on the EU have largely been confirmed on the leeward side of the vote:

  • The pound, at $1.3634 to the US dollar will likely experience further downside pressure as banking and financial service operations bow to the expected restriction on euro-denominated trading outside EU borders. British debt will likely come under close scrutiny by credit rating agencies in light of the Brexit vote. Britain's current account deficit is the largest among the G4 economies. Combined with the carve-out of the London financial district due to restrictions on trading euro-denominated assets outside the confines of the EU will put downward pressure on pound-based assets and credit ratings. Shorting the pound will continue to be the option of choice;
  • The yen soared against the dollar in the wake of the Brexit vote. The expectation here, short of intervention by the Bank of Japan (BOJ), is for the yen to continue to appreciate against the dollar until the Fed pulls the trigger on the federal funds rate. The probability of such a Fed move is negative for the rest of the year, according to market expectations. The Currency Shares Japanese Yen Trust (NYSEARCA:FXY) remains in play. An intervention by the Bank of Japan to arrest the rise of the yen would bring into play Powershares Japanese Government Debt (NYSEARCA:JGBL). The BOJ already purchases ¥80 trillion of Japanese government bonds a year, but recent history of ultra-low interest rates coupled with the BOJ decision to drop overnight rates into negative territory in January have led to a Japanese corporate cash hoard estimated at ¥50 trillion that lies fallow in local banks and offshore accounts around the world. Another ¥20 trillion in foreign stock investments could set into motion an outsized flow into government bonds. The rally in Japanese bonds has pushed the 10-year benchmark to a yield of -0.192 at Friday's market close;
  • The US dollar as captured by the Dollar Index (DXY) should continue to benefit from international capital flows into dollar-based assets in the immediate post-Brexit timeframe while investors sort out the complexities and ramifications of the aftermath. Long bets on US Treasuries include iPath US Treasury 10-year (NASDAQ:DTYL);
  • The German Bund will continue to be the recipient of European institutional capital flows as liquidity drains out of more peripheral economies of the EU. DB German Bund Futures (NYSEARCA:BUNL) remains a strong play to capture the resulting price appreciation of German debt;
  • The Swiss franc will remain a smaller but not insignificant play in the aftermath of the Brexit vote as largely European investors seek safe haven vehicles on the European continent. While not a member of the EU, the franc has traditionally played a safe harbor role in the wake of euro volatility. A long play on the Swiss franc is Currency Shares Swiss Franc Trust (NYSEARCA:FXF);
  • In the absence of a Fed move on the federal funds rate, underlying fundamentals of the euro-zone - already anemic by most measures - will dictate the direction of the euro. That direction will likely skew to the downside as investors weigh the damage to sentiment and institutional stability. A messy and prolonged divorce will exacerbate the euro's slide as sentiment on both sides of the Channel are likely to hit new lows.

Cocoa futures volume spiked on Tuesday the 21st of June as traders placed 2,239 10-metric ton contracts. Prices per contract went from an opening bid of $45.74 to an above trend $47.10 price at the day's market close. By Friday prices had returned to trend of roughly $45.

Not unexpectedly gold had a banner day the day of Thursday's vote, starting the day's trading at $1,254.10 and ending the day at $1,354.80 - up 8.03% on the day. For the year, the price of gold started at $1,077.30 and has advanced to $1,319.10 through Friday's close - up 22.45% on the year. The Central Fund of Canada (NYSEMKT:CEF) is now up 37.54% on the year. SPDR Gold Shares (NYSEARCA:GLD) and iShares Gold Trust (NYSEARCA:IAU) are up 24.20% and 24.34% respectively through Friday's market close. Given the uncertainty surrounding the aftermath of the Brexit vote, gold's rally will likely continue for the foreseeable future.

The CBOE VIX index surged to a reading of 25.76 at Friday's market close, above its long-term average reading of just over 20 on data back to 1990 and down from its high reading for the year of 28.14 set on the 11th of February. For the year, the VIX is up just over 24% on the year.

The road ahead remains uncertain. Investors from Tokyo to Berlin, New York to Rio de Janeiro will work hard at mitigating risk. The Brexit vote was not a black swan event that crashed to earth like a meteoric strike from beyond. Still, it will take time for markets to price in the necessary adjustments.

Disclosure: I am/we are long BUNL,JGBL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.