Financial markets have been volatile since the UK’s referendum on membership of the EU last Thursday. Within the NiGEM team we are constantly monitoring developments to inform our view on the outlook for the UK economy, which will eventually result in our updated quarterly forecast to be published in August. Financial market prices in the week since the referendum seem to validate our prior assumption that markets expect a persistent risk premium to open up in sterling, although there is some evidence this has been delayed as the timetable for exiting the EU has been pushed back. Recent falls in gilt yields have been driven by simultaneous reductions in interest rate expectations and term premia, with the former likely reflecting a more subdued outlook for the UK economy. The latter is contrary to our pre-referendum assumption and seems to suggest that the demand for safe assets in a period of heightened risk is dominating the elevated risk associated with UK government bonds. Equity markets have also suffered which, if it were to persist would simultaneously raise funding costs for businesses and reduce activity and spending through the wealth channel. Lastly, we show that these movements are not restricted to the UK, but that the relatively few data outturns we have post-referendum suggest that there could very well be sizeable spillovers to our European neighbours.
NiGEM Observations is a series of occasional notes published by the NiGEM team on topical macroeconomic modelling issues for NIESR corporate sponsors and NiGEM subscribers.