The historic vote in the United Kingdom to leave the European Union sent shock waves through global financial markets, dropping sovereign bond yields and supporting the dollar relative to the pound and the euro. The discreet event is over, the incremental events are just beginning. The UK will delay invoking Article 50 as long as possible. It will be up to the next prime minister, expected to be Theresa May, to steer Britain away from the continent. When Article 50 of the EU charter is invoked a two-year clock will start ticking, defining the window for negotiations. After two years there is a hard break. The EU is expected to make negotiations as difficult as possible in order to discourage other euro skeptics from leaving. Now there are more questions than answers. Whither London? Where will be the financial capital of the EU? Can the remaining EU hold together? What is the leitmotif of the EU? Will the UK hold together? NATO? Financial markets, allergic to increasing uncertainty, shed risk and drove bond yields down, bringing the U.S. 10-Treasury bond yield to a record low of 1.35 percent in early July.
The pound sank against the dollar, now at $1.30. This will help British exports and tourism but it will also bring import price inflation. Likewise, the euro fell against the dollar, now down to $1.10. The Chinese yuan sank against the dollar. Japan is expected to act to devalue the yen. U.S. export industries face renewed headwinds from the strong dollar, and this will get the Fed’s attention. Conversely to the British experience, the strong dollar will tend to keep import price inflation in check in the U.S., circling back to Fed policy, and contributing to lower overall inflation expectations.
The stronger dollar and expectations of cooler global demand brought U.S. oil prices back down from about $50 dollars per barrel, to near $45. We continue to expect gradual tightening of the global oil market into next year, but that does not necessarily imply a monotonic increase in oil prices. The good news is that weekly drilling rig counts have flattened out with firmer pricing, and have slightly increased in many areas. However, the damage to the economies of energy producing states, including Texas, will not quickly reverse. We expect to see ongoing consolidation in the oil and gas sector through the remainder of this year. Fortunately, natural gas prices have also firmed up, now in the neighborhood of $2.80 per mmbtu.
The June payroll jobs data removed a key worry for the Fed as 287,000 net new jobs were added for the month, making the very weak May gain of just 11,000 jobs look more like an aberration, and less like a dramatic downshift in hiring. Still, we do expect to see a gradual downshift in hiring, visible through the second half of this year and into next year. Consistent gains in the labor force are expected to level out the unemployment rate between 4.5 and 4.8 percent.
Even with a firmer labor outlook, ongoing uncertainty about BREXIT and the timing of the U.S. presidential election freezes the Fed until at least late this year. Our interest rate forecast contains a fed funds rate hike in December. The fed funds futures market is inching back in that direction, now showing a 33 percent chance of at least one rate hike by December. We expect overall U.S. economic growth to remain moderate through the rest of this year. Stronger business investment with higher oil prices and less drag from inventories supports a small growth bump in early 2017.
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