Brexit and the central banker's dilemma

28 June 2016/No Comments
By Nick Dunbar

With a vote for Brexit, the UK has done an act of self-harm. Two big economies – the UK and the rest of the EU – that were linked and supported by a single market are suddenly weaker. The uncertainty is being being absorbed by equity, currency and credit markets.

Compared with before the financial crisis, central banks are far more proactive at dealing with market volatility than in the past. The Bank of England, Federal Reserve and European Central Bank all have large quantitative easing programmes in place, although the ECB is the only one currently buying.

That may soon change, but what are the triggers and scale of activity we should look for? Some clues can be found from the recent history of gross domestic product growth and inflation (see chart). Looking at data from the US, UK and Eurozone, bond buying is associated with periods when annualised GDP growth falls towards one per cent, and tails off when it recovers close to two per cent (the precise start and end dates may fall outside these ranges).

For the UK, a decline of GDP growth from today’s two per cent to one per cent would be sufficient for the Bank of England to take action, based on past behaviour. Given that inflation is much lower today than at the start of its previous QE purchases in early 2012, the Bank might not even wait for the economy to decline.

Following that same template, one would expect about £200 billion of gilts to be purchased, which would probably push gilt yields down well below the one per cent mark. In the case of a full-blown UK recession (which Goldman Sachs analysts are predicting as a result of Brexit), the purchases and their impact would be proportionately larger.

“So what?” might be the shrug of the provincial English and Welsh who swung the shock referendum result. They care more about immigration than economic growth, which in many cases has passed them by. And remember these are the same people who ignored the warnings of experts such as the Bank of England governor Mark Carney.

The irony is that is that the political and market turmoil following the vote makes the British dependent on the same experts they derided. They need Carney to insulate them from government bond markets, historically an indicator of sovereign creditworthiness.

Markets used to punish spendthrift or foolish countries by forcing them to pay higher interest, hitting voters in their wallets. Central banks are now dampening this process by printing money in order to buy the bonds themselves.

So Brexit puts the Bank of England in a pivotal, uncomfortable position. It will have to try and insulate British voters from the effects of their folly. But doing so will require continuing a policy that gives the central bank a dominant role in the economy, at a time when the country and parliament are bitterly divided. Like the ECB, the Bank of England may become the substitute for difficult policy decisions.

The sovereign risk tool helps put this in context. The chart below was created by selecting the options Index: ‘Global’, Chart type: ‘Treemap’, Size scale: ‘Notional/GDP’ and ‘Show central bank holdings’. The sizes of the squares and rectangles are proportional to the amount of debt divided by national gross domestic product. Since GDP measures the ability of a country to repay its borrowing, using such a scale reveals how countries with weaker economies are the ones resorting to bond buying.

The purple squares show the amount of country’s debt owned by its central bank, which is overlaid on the green tiles showing the size of each country’s bond market. Japan is the biggest country measured in this way, and the UK is second largest. The Eurozone countries are in third place. Remember, the reason their squares are large is that debt is divided by GDP, which is relatively small compared to countries like the US or China. (Note that Switzerland and Nordic countries are not included in this dataset).

Drag your mouse over the green tiles for each country and you can see the market yield that each country paid on its bonds at the end of 2015. Central bank buying clearly has had an impact of yields of Japanese or Eurozone debt. Almost a third of all Eurozone government bonds now have a negative market yield, according to iBoxx data.

Then look at the UK and get a feeling for Carney’s dilemma. Another round of bond buying would take the Bank of England into Japanese territory, with government bond holdings over 50 per cent of GDP. If that happens here, the experts will finally be running Britain.

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