With the dust settling on the Brexit result, we take a look at the result from an Australian perspective.
On Friday 24th June, we all heard of the unexpected vote in favour of “Brexit” – Britain’s decision to leave the European Union. The UK voted to leave the European Union following a referendum held on Thursday (UK time). The ‘Leave’ vote was 17.4 million or 51.9% of votes while the ‘Remain’ vote was 16.1 million or 48.1% of the votes cast. However the the question remains, what effect will that have on us in Australia?
What happened next?
The biggest impact was on the pound, especially against the US dollar, which has fallen to $1.32, its lowest level since the mid-1980s. The weaker pound reflects the expectation that Britain will be a less attractive destination for foreign investment; with a 7% current account deficit in the last quarter of 2015, Britain needs to attract foreign capital. Following the results, UK Prime Minister David Cameron, who supported remaining in the EU, announced his resignation. A fresh Scottish independence referendum is possible, after the Scottish government agreed over the weekend to legislate for one (given Scotland voted to remain in the EU in the referendum). There is also the possibility that other European countries hold referendums on EU membership following the UK result.
Following the vote ratings agency Moody’s lowered its outlook on the UK to negative, from stable. Moody’s currently rates the UK at Aa1. Moody’s reaffirmed the EU’s top credit rating. Standard & Poor’s global sovereign chief ratings officer, Kraemer, had said before the Brexit vote, that a vote to leave would lead to a ratings downgrade for the UK.
What impact might ‘Brexit’ have on the Australian economy?
Uncertainty is never helpful for economic activity. The UK is not a major purchaser of Australian goods and services but the EU is a major buyer of Chinese goods. If Europe slows, that could dent Chinese growth which in turn would see a dampening effect on Chinese demand for Australian good and services.
Impact on the Australian dollar
The Australian dollar fell from a high of 76.48 US cents before the referendum result to a low of 73.06 US cents. AUD has since recovered to 74.07 US cents. Against the pound, AUD has risen from a low of 0.5013 early Friday to trade close to 0.5522 this morning. While uncertainty prevails, the pound and risk currencies, including the Australian dollar, will likely remain under pressure. However, the risk is that these currencies will rebound once markets gain a better idea of the outlook. A clearer picture of the proposed relationship between the EU and the UK and what new leadership will be in place guiding the negotiations would be positives for sentiment, the GBP and the Australian dollar. A delay in the pace of further rate hikes by the Federal Reserve would be supportive of the GBP and the AUD.
Impact on Interest rates
Government bond yields fell sharply as risk aversion jumped on the UK Brexit vote, driving funds into safe haven government bonds and pushing yields to record lows. Australian 10-year government bond yields fell to a record low of 1.97%, losing 28 basis points from Thursday afternoon’s close, but have partially recovered and are trading around 2.03%. Financial market pricing for further RBA interest rate cuts this year increased to one rate cut fully priced in and 68% probability of a further rate cut.
- If financial markets remained volatile and there are follow on effects to global economic growth, the RBA would consider the implications of this in its decision making process. CPI inflation is a key consideration for the RBA’s interest rate decisions. There is a high risk that the June quarter CPI inflation is weak, which could lead the RBA to cut interest rates again. We favour the August meeting as a strong possibility for an interest rate cut by the RBA.
- US 10-year government bonds fell from 1.75% to a record intra-day low of 1.40%, before rising to 1.56%. Investors have wound back expectations for a rate hike from the Fed this year and even started to price in a small chance of a rate cut by year end. We had expected two rate hikes from the Fed later this year. It is still a possibility, although one rate hike now seems more likely, with a risk the Fed leaves interest rates unchanged this year.
- Reduced prospects of rate hikes from the Fed, increased likelihood of an RBA rate cut and the possibility of an interest rates cut or further monetary stimulus from the Bank of England and the European Central Bank could weigh further on global bond yields. However, this will be mitigated to some extent if we see a reduction in financial market volatility. This could lead to a reversal in safe haven flows into bonds and put some upward pressure on bond yields.
All this said and done, things are rarely as doom and gloom as they first appear in the world of finance. Markets have already bounced back somewhat after the initial dive which was fully expected, and we all hope they will continue to do so. Some uncertainty will inevitably remain while the dust settles in Europe and indeed until the result of the Federal election is announced in Australia. However, we will keep moving forwards, as should you!