Brexit: Different interest rate paths under different scenarios

October 31, 2018 09:00
Leading figures from UK opposition parties meet with European Union's chief Brexit negotiator Michel Barnier in Brussels on Oct. 25. Photo: Reuters

Ever since the ‘Brexit’ vote there have been concerns about the potential negative impact on the UK economy because of uncertainty ahead of the official leave date in March 2019. Due to ‘Brexit’ economic growth has slowed and, notably, fixed investment has started to fall off. The Bank of England’s rate policy has therefore been more muted given the deteriorating investment climate. The BoE has mostly ignored the rise in core inflation due to the depreciation of the currency and let real short rates fall deeply into negative territory.

Quantifying a potential premium because of the uncertainty about ‘Brexit’ is difficult, but looking at the term structure of interest rates in light of the current cycle yields offers some insight. Judging by the UK Overnight Indexed Swap rate (OIS) OIS curve, the market currently implies a ‘terminal’ short rate of only 1.6 percent with a top of 1.7 percent for the cycle. Average UK core inflation over the past 20 years has been around 1.5 percent. If we assume this to be a valid long-term estimate of future core inflation, the market currently prices in a roughly zero percent real ‘terminal’ short rate, implying a scenario of extremely low real growth. Given the current state of the rate cycle, this is unusually low, strongly suggesting a negative ‘Brexit’ premium currently built into the yield curve structure. Even the Euro OIS implied forward curve eventually crosses over the UK curve.

We attach a 55 percent probability of an ‘orderly Brexit’, implying that there is a 45 percent chance that either there is no deal or that Parliament rejects the deal. In both cases, the first reaction would probably be a spike in volatility in UK financial assets and a flight to safety resulting in a short-term drop in UK government bond yields. However, markets would quickly turn their attention to a likely second referendum. The potentially negative economic news flow and heightened uncertainty would likely tilt the odds in favour of the UK remaining in the EU.

In the case of ‘no Brexit’, we would expect UK yields to move higher. This would happen despite lower inflation (strengthening Pound Sterling) as real yields would need to adjust upwards in the order of 50bps, reflecting the improved growth profile and a more pronounced rate cycle.

A ‘disorderly Brexit’ would cause an economic shock and would likely trigger a recession with Sterling depreciating significantly. Short-term rates would be cut at least 50bps, dragging the whole yield curve markedly lower. Inflationary and fiscal concerns would probably lead to a steeper yield curve. There would have to be an extended period of low interest rates until a future economic profile and trade architecture could become more visible.

An ‘orderly Brexit’ would still face uncertainty about the shaping of a future trade deal. The implied premium would most likely decrease since a ‘disorderly Brexit’ would be off the table, causing rates to adjust upwards. However, the adjustment would be more gradual given continued uncertainty about the future trade deal.

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Fixed Income Strategist, Bank J Safra Sarasin