Brexit is the shorthand way of saying Britain is considering an exit from the European Union. In short the European Union is political and economic union of 28 sovereign states (countries) generally located in Europe. There is a common legislature, common laws, consumer rights, people and goods can move from one member to another freely, single currency (Euro) generally, common phone charges, etc. Britain is considering leaving the EU under the thought that it imposes too many rules on business and charges large membership fees with little return. Britain also wants to take back control of its borders. The argument for Britain to stay is that membership in the EU does provide economic benefit and a cheaper source of labor to assist in growth. Additionally it’s generally believed that Britain leaving the EU will damage it’s reputation as being a less secure nation no longer being part of a 28 nation club.
Regardless of opinions on whether or not they should stay or go, the uncertainty is disrupting markets. Fear has plague stocks and the ‘risk off’ trade had pushed the 10yr down to 1.57% last week, the lowest level since 2012. Today it stands at 1.68% as some of the uncertainty is leading to cooler heads and perhaps the repercussions of a Brexit won’t be that devastating to markets. However at the same time we’ve seen bond yields abroad in some countries fall below zero.
Negative rates are very rare but do happen. In this scenario a central bank charges interest to hold an institution’s money. In effect it’s a method to punish banks that hoard cash instead of extending loans. Call it desperation; in some respects it becomes a method of last resort. So why would an institution agree to negative rates on deposits with their central bank or buy a bond with a negative return? The alternative could be an investment with a larger negative return, a deflationary environment, a currency play, etc. Regardless it’s a signal of desperation, a signal of economic weakness. Germany’s 10yr earlier this week fell below zero, Japan has had a policy of negative rates for quite some time and Switzerland’s 10yr is below zero today.
And this is what is weighing on markets. Economic weakness around the globe is pushing a ‘flight to quality’ and certainly US Treasuries have benefitted despite the Fed’s objective to raise interest rates. I’ve said it before and I’ll say it again, it’s very possible the Fed raises interest rates in 2016 at least one time and it’s very possible that long term rates, especially mortgage rates don’t move at all. It’s also possible the Fed doesn’t raise the benchmark rate and long term rates could go up or down. The degree of uncertainty is very high and the FOMC lacks credibility. It’s a dangerous time when there is a belief that no one can take control of the markets. It’s an environment that lends itself to lower rates. It’s an environment that can snowball.
10yr Bond Yields Around the Globe:
United States 1.68
United Kingdom 1.28