As the opening salvos from Brexit recede and markets experienced a modest reprieve on Tuesday after two days of hefty selling, investors are gaining some comfort from signs that turmoil appears contained.
Equities, led by bank stocks, UK home builders and airlines along with the currency market have been the focus of heightened activity since the UK referendum result dawned last Friday.
The pound and share markets remain well below last week’s levels, with sterling at a 30-year low, however one striking element so far has been the relatively contained reaction across the broader financial system.
Dollar strength for example has not triggered a broad rout across emerging markets. Currencies such as the Russia’s rouble, Indonesia’s rupiah and Brazil’s real have been resilient so far, while China’s renminbi has also behaved relatively well.
Still, the key currencies to watch are the pound, euro and the yen. While the pound gained over 1 per cent on Tuesday, it eased back and many expect a shortlived reprieve.
“Since the Brexit vote was the catalyst for global equity market weakness, the value of the pound needs to stabilise before equity investors will feel the worst is past,” says Nicholas Colas, chief market strategist at Convergex.
Playing a key role in any equity market recovery — after a record two-day loss of $3tn— are financials. After suffering a battering over the past two days, bank shares enjoyed a solid bounce on Tuesday. The Euro Stoxx bank index rose as much as 5.5 per cent following its two-day swoon of 24 per cent. UK and US banks were also firmer and showing early signs of establishing a floor.
In a similar vein, the euro has stabilised above $1.10 for now, while traders remain wary of pushing the yen towards ¥100 against the dollar and spurring aggressive action from the Bank of Japan.
Bilal Hafeez, analyst at Nomura, points out that at the end of last week, pretty much every market on the planet was tracking sterling. “With a few days to digest the Brexit shock, markets are starting to discriminate more carefully,” he says.
“EM risk has picked up, but remains below the one-standard deviation mark. This latter point suggests that, for now at least, Brexit is not translating into a broader EM shock. It therefore makes sense to us to view Brexit as a negative European shock, rather than a global shock.”
The dollar has sapped commodities at the margin, but oil prices have only slipped back below $48 a barrel, a level seen in mid-June.
Turning to government bonds, top-tier yields have fallen to record lows, led by Japan and the UK 10-year gilt breaking below 1 per cent for the first time. The 10-year US Treasury note yield has also dipped under 1.50 per cent, not too far away from its 2012 record low of 1.38 per cent.
A signal that Brexit fears are overblown will sound if bond yields return to levels seen before UK polls closed last week — that’s around 1.35 per cent for the 10-year gilt and 1.75 per cent for the US benchmark.
Crucially for now, eurozone periphery yields have been contained, in part reflecting the European Central Bank’s massive bond buying efforts. For now, sharply lower share prices for banks across the region is not feeding a nasty sell-off in peripheral debt.
As Alan Ruskin, strategist at Deutsche, notes: “This is not to gloss over the scale of the political crisis that confronts the UK and the EU, but more to affirm that the financial dislocation is contained, and is likely to remain so. Do not fight the risk recovery.”
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