In common with other areas of the global financial markets, the interest rate and inflation markets have seen a marked increase in volatility since the announcement of the UK referendum result, reflecting the fact that a ‘Remain’ outcome had been largely priced in.
The reaction in the markets over the course of the first day has been to price in a more negative outlook both for the UK and global economies. Markets have also immediately moved to price in an increased probability of monetary policy responses both in the UK and internationally.
There has been increasing speculation that the Bank of England may move to cut interest rates. However, while supporting demand is appropriate the economic costs of exit will come largely through reductions in trade which reduce efficiency and this is not something large amounts of monetary stimulus can fix. Thus it seems unlikely the BoE would go as far as negative interest rates. If the Bank of England does deem that more monetary easing is appropriate, we believe this is more likely to take the form of cutting interest rates 25 to 50 basis points and then possibly more quantitative easing.
Unsurprisingly, inflation markets have also priced in lower inflation and growth expectations, again, both in the UK and internationally. In the near term, however, the reduction in UK inflation expectations may be counteracted by the fall in sterling. Indeed, at the time of writing, the pound stands close to a 30-year low versus the US dollar, where it appears to have found some initial stability and very short term RPI swaps are pricing a small increase in inflation.
Making an assessment of the outlook for the GBP/EUR rate is more challenging, as the outcome of the vote is being interpreted by the market as being potentially as much a negative for the Eurozone as for the UK, both because the reduction in trade applies to both economies and this result may empower other EU sceptics. Nevertheless, the initial move has understandably been for sterling to cheapen versus the Euro.
The overarching impression is that markets are likely to witness a potentially extended period of volatility. Against this backdrop, within the Old Mutual Absolute Return Government Bond Fund we have considered it appropriate to maintain volatility towards the lower end of the fund’s target range. While we expect this scenario to prevail for some time to come, we will remain alert to the potentially attractive valuation anomalies that can emerge during times of market dislocation.