- Weekly market focus
- Brexit will cause slow-motion heart burn for markets for the next 2+ years
- Federal funds futures curve plunges as Fed rate hike is not expected until 2018
- Markit U.S. services PMI expected to move mildly higher
Weekly market focus — The markets this week will focus on (1) the aftermath of last Thursday’s Brexit vote as the markets further assess the extent of the macroeconomic and financial damage that will ensue from the 2+ year Brexit process, (2) whether world stock markets can stabilize and recover somewhat this week or whether the markets will continue to move lower on Brexit worries, (3) ongoing analysis of the shift in Fed policy due to Brexit as the markets are now discounting virtually no chance of a Fed rate hike this year, (4) world interest rates as safe-haven demand from last Thursday’s Brexit vote pushed more sovereign debt into negative yield territory, and (5) the outcome of yesterday’s Spanish election vote and whether the Spanish political parties will be able to form a stable government.
This week’s U.S. economic schedule is busy with key reports including (1) Tuesday’s Q1 GDP revision (expected +1.0% from +0.8%), (2) Wednesday’s May PCE deflator (expected +1.0% y/y vs April’s +1.1%; core expected unchanged from April at +1.6% y/y), and (3) Friday’s June ISM manufacturing index (expected +0.2 to 51.5 after May’s +0.5 to 51.3).
Brexit will cause slow-motion heart burn for markets for the next 2+ years — Last Thursday’s surprise Brexit vote will (1) encourage euroskeptics in the Eurozone to mount their own “leave” campaigns, (2) possibly cause a recession in the UK and new stimulus measures from the BOE, (3) potentially destabilize the European banking system, and (4) cause sterling and euro weakness and corresponding dollar strength. The markets in coming months will be peppered by negative announcements by companies of layoffs in the UK and decisions to move business operations out of the country, along with stronger media play for remarks by euroskeptic politicians in Europe.
The good news was that last Friday’s sell-offs were relatively contained and did not involve any bank runs or panic sell-offs such as those seen during the Lehman bankruptcy and the global financial crisis. Brexit was a very negative event but it did not rise to the level of a systemic crisis, particularly since it will play out slowly over the next 2+ years.
UK and EU officials will be meeting furiously this week as they decide on how to proceed. UK Prime Minister Cameron last Friday resigned as prime minister, opening the way for a new pro-Brexit Prime Minister to lead the charge towards Brexit. Mr. Cameron said that he would not immediately trigger the Article 50 EU exit clause, leaving that to the next PM when he or she is named by October. When the Article 50 exit clause is triggered by the UK, then the specified 2-year period will begin for exit negotiations.
Even if UK exit negotiations are completed within the specified 2-year time frame, it could take upwards of another five years for all the EU members and the European Parliament to approve the UK exit program, meaning the UK could be facing up to 7 years of uncertainty until its EU exit becomes final.
It should be noted that Brexit is not necessarily a done deal. First, last Thursday’s public referendum was not legally binding and there is nothing to prevent the British government from calling for a second referendum at some point if the UK public suddenly shifts to being strongly against Brexit. Second, the British parliament may not be able to approve legislation implementing Brexit if the Scottish nationalists carry out their threat to block Brexit in Parliament.
Federal funds futures curve plunges as Fed rate hike is not expected until 2018 — The U.S. markets now have some assurance that the Fed will not raise interest rates this year, but that assurance came at a high cost. Brexit and European uncertainty is likely to tamp down U.S. business and consumer confidence and fuel strength in the dollar, which is negative for U.S. GDP growth and corporate profits.
The federal funds futures curve last Friday plunged by up to 14 bp for the 2016 contracts and by 15-19 bp for the 2017-2018 contracts. The market is now discounting a zero chance for a Fed rate hike at the next three FOMC meetings (i.e., July 26-27, Sep 20-21, Nov 1-2) and a negligible 4% chance of a rate hike at the Dec 13-14 meeting. The market is discounting only a 32% chance of a rate hike by mid-2017 and a 72% chance of a rate hike by the end of 2017. The market is not fully discounting the next Fed rate hike until May 2018, roughly two years from now.
The FOMC can only be shell-shocked at this point having first been blind-sided by the May payroll report of +38,000 (+73,000 ex-Verizon strike) and now by the UK Brexit vote. Not only is there no chance of a rate hike this year, but the Fed could actually end up implementing new easing moves by early 2017 if payroll growth tanks in coming months, threatening a U.S. recession.
Markit U.S. services PMI expected to move mildly higher — The market is expecting today’s June Markit U.S. services PMI to show a +0.7 point increase to 52.0, reversing about one-half of May’s -1.5 point decline to 51.3. The index is not in particularly good shape having fallen below the boom-bust level of 50.0 in February and currently being only +1.3 points above that boom-bust level at 51.3. The ISM’s non-manufacturing index is in a little better shape at 52.9, but that is still not far above the boom-bust level of 50.0 and indicates only modest optimism among service-sector executives. The markets are expecting this Friday’s June ISM manufacturing index to show a small +0.2 point increase to 51.5, adding to May’s report of +0.5 to 51.3.
