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Rrexit, Fed, Brexit - What's Moving the Markets?

Posted On Monday, Jun 20, 2016

With the ongoing uncertainty of Brexit, there has been an important development in Indian markets. RBI Governor announced that he would not be there for his second term and since this would mark the exit of the current RBI governor, it is popularly put in current context as “RRexit”. Although timing of this is seen with suspect since it arrives at a time when a global event looms large. But looking beyond that the reasons seem to be much obvious that the 150 basis points of rate cuts seems to fall short of government’s expectations at a time when rapid growth revival was what they were craving for. All the other policy measures put in place and cleansing of bad loans have further slowed the pace.

The markets as of now seem to have shrugged off the “Rrexit” but the successor announcements will cause markets to react. If the government brings in a candidate that fulfills on their rate cut mandate by reversing some of the crucial policies importantly the real interest rate framework, it would undermine confidence of foreign investors and thereby cause a capital flight and adversely impact the Indian currency. It’s important for the new governor to showcase the credibility and independence of the central bank otherwise it may not go well with investors.

The guess on Fed hikes is still on

On expected lines, Fed stayed pat on interest rates in their last policy meet. Although, we did expect Fed to at least prepare markets for rate hike in July / September. On the contrary, the Fed was extremely dovish. The Federal Reserve portrayed an indeed cautious stance and signaled their lack of confidence in the economy by lowering its long run economic projections and less aggressive tightening cycle.

The economic growth projections have been cut slightly to 2.0% for 2016 from 2.2% in March. Even these rates are optimistic and convey that the 1Q weakness was a one-off. That seems unlikely and many indicators are pointing towards a slowdown in the growth momentum. The Fed admitted that the pace of improvement in the labour market has slowed but counters this with the observation that growth in economic activity has picked up. If the Fed is right and the US is able to record growth around 2% this year it will surely raise rates and as always start preparing markets well ahead of a rate hike. Logically this should be positive for the dollar.

However, the markets do not buy this argument and see little possibility of rate hikes this year. Markets in a way reflect on Fed dots which have shifted down from March i.e. the FOMC members have also lowered their expectations of rate increases. The majority at the Fed still expects two 25bps rate increases by year-end but there are now only two members that are more hawkish (compared with 7 members in March) whereas six from the 17 are more dovish (only one in March). FOMC members are still relatively more hawkish than markets where a 58% probability of no change in rates by the December FOMC and a 33% chance of one increase. What’s worth highlighting is that even steady Fed hawks backed away from pushing for a hike at last meeting which makes the Fed stance more dovish.

Several economic indicators indicate that the US slowdown has broadened beyond the immediate multiplier effects of oil meaning that it will be harder to see investment rebounding even when oil and gas exploration spending stops falling. If these worries are correct then the Fed will not tighten and Fed funds futures will be correct to be dovish and that would be negative for dollar and bullish for gold.

The more pressing “Brexit”

The June 23 referendum on whether or not the U.K. should leave the EU is fast approaching. New polls show that those favoring a leave vote or "Brexit" are leading. This has sent ripples through the markets, as a Brexit is feared to cause economic chaos across European region, instability in the banking and financial sector and may drag the region into a recession.

In a real sense, the Brexit question represents the political conflict rapidly spreading across the globe. The political world is mainly concerned about contagion where several other nations may feel emboldened by a Brexit vote and decide they also want to leave the failed experiment known as the European Union. While economic alliances, trade and commerce make sense, ceding sovereignty is probably not the wisest move for nations wishing for the economic boost. This becomes very important when you are governed by a supra national regime like the European council which is neither elected by the people of that country (UK here) and nor are people empowered to change or remove them even if it persists with errors.

Therefore, Brexit is not much about Britain having to fund the EU budget, its more about their fundamental sovereign rights to stand up against the evils of erroneous policy making like immigration / asylum which has been the biggest motivating factor behind the current referendum.

Yes, it does come during testing times for UK. It is compelled to make this difficult choice when the current account deficit has surged to 7% of GDP (highest in several years) and is therefore dependent of foreign flows to fund it and therefore the sterling pound (UK currency) is vulnerable to a loss of confidence from foreign investors.

Beyond this short term ramifications for the currency, it’s unlikely to be unmanageable for the UK. The political elite continue to warn against Brexit as they are worried about the “contagion” spreading to the rest of Europe. France has already made it clear that it would seek to make the new economic reality for the UK as difficult as possible in order to discourage any more countries from leaving. Leaving the EU will simply mean that there would be no economic barriers to trade. Important will be for UK to pronounce favorable and open terms of trade and be guided by the global rules for trade as framed under the WTO. Hongkong is a good example of flourishing trade without any barriers and has done exceeding well even in the current protectionist regime that prevails.

If history is any guide, at the end of the day its likely that Bremain would rule over Brexit even though the polls show otherwise. We have seen in cases like that of Quebec or more recently of Scotland which at the end leapt the other way even though the polls showed the risk. This is likely because at the end people choose to opt for the known’s rather than uncertainty of the unknowns.

Beyond Brexit

Going forward, Brexit may cause volatility in markets and gold to rise but things will stabilize post the event. The focus will again shift to underlying economies mainly the U.S and central bank policies. In the U.S., we still think that two rate hikes are possible for this year but now we are more leaning towards may be one given the dovishness at Fed. As and when Fed raises rates, may be in July or September, there could be some correction on account of speculation surrounding further rate increases. However, our underlying view remains that Fed will stay behind the curve and keep rates specially the real rates lower for much longer and that remains positive for gold.

But if the market assessment of no rate hike remains correct, it would be extremely bullish for gold. This is possible but remains relatively low probability (not impossible though) as of now as we believe in the rate normalization theory as market distortions hamper real growth with its other negative consequences and cannot last for infinity. Given the Japan experience where they tried raising rates from the zero bound in 2000 only to roll back just seven months down the line. Similarly in the U.S, the rate hike odds for July are plunging to almost zero and the rate cut odds are starting to rise aggressively. And, of course, when that too fails, the Fed will bring back QE i.e. print money again. If this scenario unfolds, it will be extremely bullish for gold.

Data Source: Bloomberg

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