Saturday, June 18, 2016


 Backdoc Alert

This could be the week the UK breaks up with Europe
Thursday's vote by the U.K. on whether to exit the European Unionshould bring an end to weeks of uncertainty, but markets could very well remain volatile no matter what happens.
There is a wide variety of outcomes expected. The majority view in financial markets has been that the U.K. will stay in the EU, while many recent polls have shown those supporting leaving the trade bloc have taken a slight lead. That said, markets could still see a major shift in either direction when the results are released early Friday morning U.K. time.
Even with lots of pre-positioning, analysts say if the vote is to leave, the pound could fall further, stocks and commodities sell off and investors would seek safe havens like gold and bonds. A vote to stay may have the opposite effect, causing a snap back in the pound and risk assets and a sell-off in bonds.
Brexit in London
"Markets have become increasingly sensitive to the polls as the gap has closed. We still think the odds are strongest in favor of staying. What that does is it set up a binary outcome where it sets up the potential for a big surprise if they vote to leave," said Paul Christopher, Wells Fargo Investment Institute head global market strategist.
Another big event in the week ahead is Fed Chair Janet Yellen's two days of testimony on the economy before Senate and House committees Tuesday and Wednesday. Little new is expected from the Fed chair, after Wednesday's postmeeting statement and forecasts on the economy and rates.
"It's hard to see her deviating from the press conference she just had. I don't know how [Yellen] go[es] from being as uncertain as [she was] Wednesday to gaining certainty next Tuesday," said John Briggs, head of strategy at RBS.
The Fed this past week rolled back its expectations for interest rate hikes for the next couple of years and signaled it may only have one hike this year. That unsettled markets since the Fed just several weeks ago was indicating it wanted to hike rates this summer. The news was taken particularly hard in the bond market, where yields have been moving into historically low ranges due to central bank easing and concerns about Brexit.
"She'll probably be asked about the international issues and the linkages to the economy, so she might sound a little bit more cautious," Michelle Meyer, Bank of America Merrill Lynch deputy head of economics.
But market focus will most likely be dominated by Brexit. The implications of the vote are difficult to discern, with one European official saying this past week that an exit "could be the beginning of the destruction of not only the EU but also of Western political civilization."
The Bank of England has warned of risks of recession and threats to financial stability that could spill over into the global economy, and it says sterling and stocks could fall further. The Bank has put contingencies in place in the event it would need to support banks, and it and other central banks are preparing to help maintain stability.
But some in the market see these warnings as overly dramatic, and they say a buying opportunity could open up in markets after an immediate shakeout.
"Given markets have priced in a decent chance of both outcomes, we think reasonably large moves and most certainly some volatility can be expected whatever the result at this stage. One other key point to keep in mind is that if the vote is close, especially with a leave result, we would expect speculation around the possibility of a second referendum. This may not come to pass … but nevertheless, even such speculation could add to volatility in the days after the result is announced," wrote Nomura rate strategists.
Christopher said aside from market reaction, the impact on the U.S. economy would actually be minimal since the U.K. is not a big trade partner with the U.S., and there is a two-year period for the U.K. to work on its exit with the EU. Critics have focused on the arduous task of unraveling the U.K.'s position in the European trade bloc and realigning trade relationships.
There are also varying expectations on how impactful the vote could ultimately be on the structure of the 28-member European Union and the 19-member eurozone, the countries that use the euro. The big fear has been that the British would be just the first to depart the EU, prompting disgruntled core eurozone countries to choose to exit, threatening the future of the single euro currency.
"The U.K.'s been a marginal member of the EU. They've never been an active participant. To pull out of that, I don't think it's a major event," said Robert Sinche, global strategist at Amherst Pierpont. However, if a euro zone country tried to leave, that would be a much bigger deal. "To pull out of the single currency is a huge event," he said.
"I think there is this risk that we pre-positioned for a bad outcome in Brexit. It's in the bond market, and it's in the currency market. I think even if Brexit happens, it's more of a knee-jerk reaction," said Sinche, adding those positions including a near-record short in the pound, would have to be unwound.
If the U.K. votes to leave, "it could be very negative, but the epicenter would be the U.K., maybe some spillover to Europe and little to the U.S. We don't think this is going to be a major factor for the global economy and the U.S. economy," Sinche said.
The vote comes at a time when markets were already testy, with global bond yields falling to record lows and some, such as the 10-year German bund, falling into negative territory. The 10-year Treasury yield fell as low as 1.47 percent, its lowest since 2012. The 10-year was yielding about 1.60 percent late Friday.
Stocks were lower on the week, with the S&P 500 down 1.2 percent at 2,071.
"It's going to take a long time for a separation to be felt," said Christopher. "On a strong negative vote, you could test [S&P 500] 2,000 or a little bit below, at support levels. We think it's going to be a buying opportunity."
Christopher said the 10-year yield could test its all-time closing low around 1.39 percent. "You could hit that again," he said. "We think investors should stay in the middle of the curve and look for high-quality corporates."
"The interesting thing is we could see the currencies against the dollar moving in different directions, maybe offsetting each other. You could see the pound at 1.30, 1.25 even. You could see the euro weaken but not as much as sterling," said Christopher. The pound was trading at about 1.43 against the dollar Friday.

The Only Certainty for World’s Central Bankers Is Uncertainty

From the immediate possibility of Britain leaving the European Union to the longer-term consequences of aging populations, the world’s major central banks this week just aren’t sure what to do next.
Officials from the U.S., Japan, the U.K. and Switzerland all opted to keep monetary policy unchanged this week as they await the June 23 Brexit vote and try to make better sense of the deep-seated forces shaping their economies.

“We are quite uncertain about where rates are heading in the longer term,”
 Federal Reserve Chair Janet Yellen told reporters on Wednesday, noting that an aging society and lagging productivity growth suggested borrowing costs should be below historical normal levels.
The lack of action by four of the most prominent central banks fueled perceptions among investors that monetary policy makers are increasingly at a loss about what to do in the face of a struggling global economy and distorted world financial markets.
That feeling, coupled with worries about the fallout should the U.K. opt out of the EU, sent world stock prices skidding lower this week and drove bond yields down, in some cases into once-unheard-of negative territory.
Risk Averse
“It’s clearly risk-off for investors right now,” Susan Long McAndrews, a partner at investor Pantheon Ventures Inc. in San Francisco, said on Bloomberg Television on Thursday. “Markets don’t like the uncertainty.”
Yellen said the U.K. referendum was a reason why the Federal Open Market Committee chose to hold rates steady on Wednesday.
“It is a decision that could have consequences for economic and financial conditions in global financial markets,” she said of the U.K. vote. It also “could have consequences in turn for the U.S. economic outlook.”
Japan and Switzerland could potentially see an economically damaging surge in their currencies if the U.K. elects not to remain in the EU. It’s “possible that we’ll have turbulences” in reaction to a Brexit, Swiss National Bank President Thomas Jordan said in a Bloomberg Television interview Thursday. Officials from major central banks could act in global markets to prevent any “exaggerations,” he added.
Former Bank of England policy maker Adam Posen said the U.K. will probably face a currency crisis if it votes to pull out of the EU.
While the central bank might first try to support the economy by easing credit, Posen said at a conference Wednesday that it would eventually have to raise interest rates to restore confidence in the pound.
“The odds are you get capital flight and an interest rate hike and a recession,” said Posen, who is now president of the Peterson Institute for International Economics in Washington.
Brexit isn’t the only uncertainty central bankers are grappling with.

Monetary Setting
Yellen said the Fed is trying to figure out the best monetary-policy setting for an economy that is approaching full employment and where inflation is forecast to rise back to its 2 percent target eventually.
Since raising rates from near-zero in December, the U.S. central bank has kept policy steady for four straight meetings.
The Fed chief in the past has ascribed the low level of rates mainly to lingering headwinds from the financial crisis -- tight mortgage credit, for instance -- and suggested that such factors would dissipate over time.
On Wednesday, though, she also pointed to more permanent forces that could hold down rates for longer, namely, slow productivity growth and aging societies, in the U.S. and throughout much of the world.
Rates may be depressed by “factors that are not going to be rapidly disappearing, but will be part of the new normal,” she said at an hour-long press conference in which she uttered the words “uncertain” or “uncertainty” 11 times.
Kuroda’s Challenges
Bank of Japan Governor Haruhiko Kuroda has even bigger problems to deal with. The BOJ’s balance sheet now amounts to more than 80 percent of gross domestic product, far more than for the Fed, yet Kuroda has made little progress in lifting the country’s too-low inflation rate.
Further compounding his difficulties: A more than 15 percent rise in the yen this year in spite of the BOJ’s decision in January to push short-term rates below zero.
With the Japanese currency soaring to its strongest in almost two years after the BOJ held policy steady on Thursday, Kuroda told reporters in Tokyo that the central bank won’t hesitate to take action if needed.
He also said the central bank was carefully monitoring moves in financial markets and was in touch with counterparts including the Bank of England.
Still, the BOJ may not have the power to break the economy clear from a deflationary cycle, said Michael Every, head of financial markets research at Rabobank Group in Hong Kong.
“They really are in dangerous territory on the exchange-rate front,” he said. “If they make any more policy errors or missteps, or they don’t jawbone correctly, the real economic damage could be quite significant at a time the economy is already weak.”


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