Holy &%$# — now what? Questions for the day after

24/6/2016

By Cardiff Garcia and David Keohane

That’s it.

That thing that seemed first impossible, then worryingly plausible, then shockingly probable — it’s actually happened.

The stunning vote for Leave hasn’t just cratered financial markets. It also introduces a period of baffling uncertainty that, we suspect, far too many advocates of Remain have been too complacent about ever having to face one day.

But ready or not, it’s here. As far as we can tell, these are the immediate questions raised by the stunning outcome:

– What is the bottom for markets?

Expect dramatic fluctuations in the initial hours and days. To the extent that market participants accurately try to anticipate broader economic outcomes, they have a challenging task ahead. Consider the many estimates for how much Brexit would force the UK to deviate from baseline economic growth. A drop of 2 per cent was commonly cited, but for instance this argument from the Economist Intelligence Unit that the likelier number is 6 per cent seems just as reasonable.

The mother of all Keynesian beauty contests has begun as market players try not to just reckon which economic path is most likely, but also what other market players reckon is the right path. Add the infinite complexities that will come with the political response, whatever it will be, and markets are certain to make many reassessments along the way.

A chart of uncertainty across countries from Goldman might make that point too:

– Will Mark Carney move swiftly to loosen monetary policy if liquidity dries up quickly?

The decline in the pound will do some of the initial work here — as Kit Juckes at SocGen said, “the view of policymakers will be that a weaker pound is a vital economic shock absorber” — but the severity of its drop will surely also prompt the BOE to not only loosen policy but to add reassurances about shoring up liquidity. At this point it’s not crazy to wonder if the UK will beat even the BOJ to using helicopter money, as some analysts have suggested. From BoNYM’s Simon Derrick, for example:

''Taking this into account we need to ask whether any official action might be taken to support UK markets. Firstly, we need to remember that the minutes of the meeting of the Monetary Policy Committee ending on June 15 emphasised that the referendum was the largest immediate risk facing British financial markets. They added that “through financial market and confidence channels, there are also risks of adverse spill-overs to the global economy.” That certainly suggests they would wish to take action of some form if they became sufficiently concerned about spill-over.

Secondly, we need to remember what Chancellor George Osborne had to say on LBC radio earlier this week. When asked “If the financial markets do plummet on Friday would you have to consider suspending trading on the FTSE?” he replied: “Well look, the Bank of England and the Treasury – Governor Carney and myself – we have of course discussed contingency plans. But the sensible thing is to keep those secret and make sure you are well prepared for whatever happens but if you set them all out in advance then you rather undermine the power of those plans.” When asked again about the contingency plans, he replied: “I have a responsibility to the people listening to this programme to do all I can to protect them.”

– How will the ECB respond?

More on the political side at the bottom, but you’d expect uncertainty and sovereign spreads to widen in the periphery. The ECB, per our inbox, will probably grant unlimited liquidity. And per BNP Paribas, who are out with a quick reaction note: “A temporary increase in monthly sovereign bond purchases is likely. And a persistent rise in risk aversion in periphery markets would require OMT activation (but it will take more time).”

– How will the Fed and other central banks respond?

Janet Yellen explicitly noted that the possibility of Brexit factored into the Fed’s decision to hold rates steady at the last meeting. If the reverberations are powerful enough, will the world’s central bank be forced to respond more forcefully — either with mild reassurances of maintaining global liquidity or with more aggressive promises to keep policy loose?

The BoJ in particular is not going to like the yen strength being experienced on the back of this — it went through 100Y against the dollar. Do read this for more on possible interventions. And don’t forget the SNB. Per Derrick again: “It is therefore worth recalling the recent comment from Swiss National Bank Chairman Thomas Jordan that “we will be monitoring the situation closely and will take measures if required.” Although he noted that the bank does not have any specific exchange rate target, the goal is to have a stabilising impact if there is a vote to leave.”

More so, it seems a solid guess that a deflationary impulse will need to be dealt with. From BNP Paribas again: “Expect yields to go lower in Japan, Germany and the US. A contraction of UK GDP by year-end is our base scenario. At the global level it will depend on the tightening in financial conditions. It will take a combination of a (1) 15% drop in global equities and (2) a 120bp widening in US investment grade spreads to push the US and then global economies into recession.” Maybe we’ll actually see the G7 get all clubby again?

– Will the UK government resign? How quickly?

Self-explanatory. Have some BNP Paribas on that one more time: “Cameron should remain in power during the transition but resign afterwards. He should promote leading Leave figures in the Cabinet. Eyes will be on Scotland where another independent referendum could take place. It is time of huge political uncertainty.” Yup.

– What are the chances that turmoil in markets and the economy lead to a second referendum?

This was a possibility floated by Credit Suisse earlier this week, by the Economist Intelligence Unit, and by a few others. The idea is that the potential for a downturn leads the public to change its mind. A pro-Remain new government seizes the opportunity and calls another Referendum. We frankly have no idea how likely this is.

– Will the UK government try to negotiate for a speedy exit or a more drawn-out process to calm markets?

Here we’ll quote from the FT’s explainer:

''Leaving the EU is a daunting challenge with no clear precedent. Brexit would unwind economic relations of “incomparable complexity and depth”, according to Stephen Weatherill, professor of law at Oxford university. He argues it would be more legally complicated than decolonisation or the break-up of sovereign countries in the past.

The negotiation would not just concern divorce, the technical parting of ways and the settling of old bills. It would also have to re-engineer the world’s biggest single market, setting new terms of access and legislating to “renationalise” volumes of law rooted in the EU. …

Drawn out divorce talks could be interrupted by elections, or a second independence referendum for Scotland, which may want to remain in the bloc. All the time, the EU would be coping with the biggest political upheaval since its inception.''

Which leads us to perhaps the most important question for the global economy:

– What will be the political fallout beyond Britain’s borders?

Actually, this is better addressed with more questions:

Will the outcome galvanise other nationalist movements throughout Europe to call for their own referendums? Will they be successful? Will we soon start hearing about FRexit? What about Sinn Fein’s promise to call for Irish reunification if Leave wins?

Maybe keep this link handy — Possible names for EU exits for all members of the EU — and have this chart from Goldman to go with it:

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