Equities may be recovering, but bond markets remain in full panic mode
By R.A. | LONDON
A WEEK ago, as news of the vote in favour of Brexit sunk in, global markets tumbled. In the space of two days, the S&P 500 dropped more than 4%, while Britain’s FTSE 250 fell about 10%. But then, strikingly, equity prices reversed themselves. The S&P 500 is now higher than it was before the vote. The conventional wisdom has quickly flipped from the idea that Brexit was an immediate financial disaster to the notion that everything will be ok. Yesterday, Paul Krugman wrote that “the arguments for big short-run damage from Brexit look quite weak”. So, will everything be ok?
Everything will not be ok.
Things might or might not be ok in the long run; there are too many questions about when and how (and even whether) Brexit will actually occur. In the short run, there is plenty to worry about, and the evidence is written all over bond markets. Yields around the world were already extraordinarily low before the Brexit vote. In the days immediately after they plummeted. While equities have risen, bond yields have not. The yield on the 10-year US Treasury is 30 basis points below where it was on June 23rd. The real yield is close to zero. The 10-year gilt yield is below 1%. The yield on 10-year bonds in Germany, France and the Netherlands are basically zero. Falling yields on safe assets indicate some combination of falling expectations for growth, falling expectations for inflation and a rising risk premium.
In America, certainly, falling long-term bond yields reflect expectations that short-term rates will be lower for longer. In the days immediately after the vote, futures markets speculated that the Fed’s next move might actually be a rate cut. While that possibility has faded, the outlook for the fed funds rate remains as flat as a pancake. Markets are pricing in roughly one rate hike over the next three years.
What exactly is going on? We can’t be certain what the exact effects of Brexit, within Britain and globally, will be. But even if the near-term outlook for global growth hasn’t changed very much, the range of possibilities has widened, and the odds of quite a bad outcome have increased.
Worryingly, central banks have very little room to respond to even a modest monetary shock. Neither short- or long-term rates can be pushed much lower. The best hope for effective monetary stimulus is asset purchases designed to weaken a country’s currency. But not everyone can depreciate simultaneously; the fall in sterling has been hard on other currencies, including the dollar, the rise of which will sap demand from the American economy. Quantitative easing everywhere could help if it boosted expectations for growth and inflation. But at the zero lower bound and with little hope of massive fiscal stimulus, central banks might well struggle to raise animal spirits.
In a world of very low inflation and very low interest rates, people only have to cling a little more tightly to their money to tip economies into recession. It’s not trade effects or investment uncertainty that threaten the global economy; it’s fear. In normal times, fear need not start a recession. But when central banks are deprived of the tools they normally use to reassure markets, a little fear is more than enough to cause big trouble.
