Brexit means Brexit, but maybe not doom?

With US markets closed yesterday, trade was primarily driven by Europe and the post-Brexit UK economic data.

London
Source: Bloomberg

The dire market consensus figures for the Services PMI looked to be off the mark as the index swung from 47.4 to 52.9. This was incredibly similar to the pattern we saw in the manufacturing PMI release as well.

UK economic has consistently beat market consensus expectations as many different data sets seem to be recovering after the initial shock directly after the Brexit vote. Citi’s economic surprise index for the UK is tracking at its highest levels since mid-2013.

This has had a major effect on the pound, which has rallied 3.3% since 15 August as these improved data points continued to roll in. The pound initially rallied as much as 0.6% off the data release overnight, but pared much of this back later in the session.

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But this better-than-expected post-Brexit UK data is starting to have some major macro consequences. The expectations for dire economic effects in the UK and Europe fuelled the drop in bond yields to new record lows in late-June. However, this was not just a European story, Japanese bond yields also fell sharply and the selloff in Japanese equities was as bad, if not worse, than many European markets as the yen strengthened dramatically from these safe haven flows.

And as the UK data has continued to surprise to the upside, Japanese bond yields have also been reversing. Japanese bonds have just seen their worst monthly since 2010. This is partly driven by the better-than-expected global macro data in the wake of Brexit, but it is also in expectations of potential changes in the asset purchasing program at the Bank of Japan’s (BoJ) 21 September meeting. There is a growing sense that the externalities of the BoJ’s negative interest rates policy have far outweighed the benefits. There is growing speculation that the BoJ is going to rein in its purchases from the long end of the yield curve. Since 23 August, the yield spread between the Japanese two-year government bond and the 40-year has risen by roughly 24 basis points.

Why does this matter? Well, the huge rally in equities in the post-Brexit period was partly supported by the massive drop in bond yields. As the respective bond yields dropped, the discount rate that one would use as a discount factor to price long duration assets, such as equities, similarly dropped, making equities look increasingly compelling as an investment, and they duly rallied in response. However, if suddenly these discount rates begin to rise, equities become less and less appealing. Particularly, in the most expensive elements of the markets.

Asia-Pacific markets look set for a bit of a mixed open with no US markets to provide much of a lead in. The ASX is pointing to a negative open and the Nikkei is looking to open flat.

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