The World has Changed
- The consequences of BREXIT will be felt over years.
- The odds of a fed funds rate hike this year are significantly lower because of BREXIT.
In a stunning rebuke to transnationalism, the citizens of the United Kingdom have voted to leave the European Union. Global financial markets were clearly unprepared for what should have been a reasonably foreseeable event. The false positive signal of the Guardian poll just days before the election added to the complacency despite notoriously inaccurate British polling. BREXIT is no doubt a historic event, not only for the United Kingdom, but also for the European Union. The immediate impacts of the LEAVE vote are still playing out in global financial markets as they grope through the uncertainty. U.S. and global equity markets sold off on Friday. Fortunately, the weekend provided a much needed, although temporary, circuit breaker. Treasury bond yields dropped as investors crowded into lower risk assets. The dollar strengthened against the pound and the euro. Gold rallied. Oil sunk.
Short Term: We expect to see ongoing, but diminishing, volatility in global financial markets in coming weeks. BREXIT was a game changer, but it does not appear to be a Lehman moment. There is not a huge avalanche of potential energy behind the vote waiting to pull down primary financial institutions in very short order. The Bank of England and the European Central Bank stand ready to provide liquidity as needed. Prime Minister David Cameron has announced his intention to step down, launching a new election cycle in the U.K. and increasing political uncertainty there. We assume that the next Prime Minister will invoke Article 50 of the EU bylaws which is the mechanism for exiting the EU. U.S. and other foreign owned corporations that have maintained a presence in the U.K. as an entry point to the EU will start shifting resources and operations toward the continent.
Medium Term: Article 50 negotiations will be contentious. The EU will be eager to make BREXIT painful in order to discourage other countries from following the example of the U.K. The U.K. will retaliate where possible, but their leverage is limited. Article 50 imposes a two-year time limit for negotiating a withdrawal from the EU, so there is a hard break if negotiations fail. Scotland may seek another referendum on independence from England. Northern Ireland faces a much thicker border with the Republic of Ireland. There could be consequences for NATO in a more contentious Europe.
Long Term: BREXIT is a fundamental challenge to the founding principles of the EU. It may no longer be meaningful to talk of an ever closer Europe. If other countries, such as the Czech Republic and the Netherlands, decide to leave the EU, setting the stage for still more departures, then Germany faces a prisoners’ dilemma. Do they try to hold together a crippled EU and face a greater burden for revenue sharing? Or do they move toward an EU Light with reduced financial obligations, or even a two-tiered EU?
Implications for the U.S.: Near term global financial market volatility puts even more pressure on the Federal Reserve to be cautious. We think that there is very little chance that the FOMC will vote to raise the fed funds rate at their next meeting over July 26/27. If the U.K. falls into recession this year without the EU following, global headwinds will be small. However, if the U.K. plus the EU fall back into recession, slower global demand growth would be a headwind for the U.S. and for Asia. An Asian recession would have very serious global consequences. Oil prices might not lift in that environment and inflationary pressure would be very weak. Central banks, including the Federal Reserve, would have to abandon their intention of eventually raising interest rates. There would be no new normal; normal would be something else. Because of increased global risk as a result of BREXIT, we believe that the Federal Reserve will be very cautious through the end of this year. For now, we are leaving one fed funds rate hike in our interest rate forecast, coming in December, but that is not a sure thing. The fed funds futures market places only a 15.5 percent change of at least one fed funds rate hike by December 14th and an equal probability of a rate cut by then.
For a PDF version of this Comerica Economic Alert click here: BREXIT 06-27-16.