Blasé about Brexit? The financial markets responses to the triggering of Article 50 and other political developments
The British Government triggered Article 50 of the Lisbon Treaty on 29 March. The announcement was widely anticipated and the financial market response was unsurprisingly muted. As we detailed in the latest issue of NIESR’s Economic Review that went out today, the road to final exit is long and other news and events since the referendum have caused more pronounced movements in financial markets.
Foreign exchange reaction
As one would expect, sterling exchange rates have been among the most responsive to EU withdrawal related news. Sterling bilateral rates were, however, stable in the week from 27 to 31 March 2017, which is consistent with the foreign exchange market pricing this event in.
But sterling was significantly affected by other political developments as is evident when looking at the 2-months implied volatility (figure 1). The referendum in June is a good example, but as the chart shows, sterling volatility also spiked in response to other news: the Prime Minister’s speech at the Conservative Party conference on 2 October 2016, her Lancaster House speech on 17 January 2017, the UK parliamentary approval of the European Union (Notification of Withdrawal) Act on 13 March 2017 and the calling of a general election for 8 June on 18 April 2017. We can also see that the magnitude of the market reaction to these events decreased with time, perhaps because these events did not represent policy shifts, but instead were interpreted as further news about the UK's position on and objectives for the EU withdrawal process. Volatility has now returned to a level even lower than its long-term average. Anecdotally, sterling declined by 0.5% against the Euro on Monday 1 May when the news was leaked that the dinner between Prime Minister May and European Commission president Junker had ended in bitter disagreement about the EU exit negotiation.
The FTSE 100 index has experienced robust growth since the referendum, increasing by 14 per cent between 23 June 2016 and 28 April 2017, and even outperforming by 1 percentage point the S&P 500 over the same period. However, when converted to US dollars, the fall in sterling offset nearly all of the gains in the FTSE 100 (figure 2). The smaller capitalisation index, FTSE 250, was even more negatively impacted by the depreciation of the currency because it is composed of companies more exposed to the domestic market, even though the gap between the FTSE 250 and FTSE 100 has been recently narrowing.
Interest rates reaction
Figure 3 reports interest rate expectations derived from the Sterling Overnight Indexed Swap (OIS) yield forward curve, published each day by the Bank of England and used as the interest rate conditioning assumption in MPC forecasts. Figure 3 shows how interest rates expectations have evolved before and after the referendum. The dates reported are consistent with the point at which we finalised our conditioning assumptions for each of the past five NIESR forecasts. After a sharp drop following the referendum, expectations have risen marginally. However, over the past three months the longer end of the curve has flatten, shifting the expectation of a first 25 basis point rate rise back from mid 2019 to the first half of 2020.
Government bonds market reaction
During the week when Article 50 was triggered, UK 10-year bonds continued a rally that had started the week before, with yields falling by 7 basis points. However, there was no out-performance of gilts compared to their European peers, as other major European 10-year sovereign bonds also rallied. Since the referendum, the yield on 10-year gilts has been reduced by 48 basis points whereas German and French bonds have increased by 22 and 33 basis points respectively. This can be only partly attributed to movements in sovereign premia which have proved reasonably stable around the triggering of article 50 (figure 4).