The RSM Brexit Stress Index moved substantially lower after talks between British Prime Minister Boris Johnson and Ireland’s Prime Minister Leo Varadkar were reported to offer options for the transition of Northern Ireland from the common market into Britain’s single market. Though details were still to be worked out, the positive developments allowed negotiations to resume in Brussels over England’s looming departure from the European Union.
The composite index, which measures financial-market stress surrounding Brexit, moved lower on Thursday afternoon – as the talks progressed — and into Friday, closing the week at 1.08 standard deviations above normal levels of stress from last week’s close at 1.40.
The bond market’s reaction to the talks was perhaps the most surprising, with the across-the-board increase in yields coming after the release of tepid economic data. England’s monthly measure of gross domestic product has decelerated for five consecutive months in the service sector. In the production sector, it has declined in 10 of the past 12 months. The gilt yield curve remains inverted, but only out to five years maturity and investors expect slower growth in the years ahead.
The Benn Act requires Johnson to request an extension to the withdrawal period no later than Oct. 19 should there not be an agreement before then. An extension is expected to calm the markets. But there are loopholes and political permutations still to be worked out, leaving an indeterminate amount of time for financial and economic uncertainty to continue. This would argue for higher volatility and risk being priced into financial assets, and the prospect of further loss of potential economic output.
Performance of index components
The RSM Brexit Stress Index is made up of six components; they include the British pound-euro exchange rate and its volatility, the FTSE 100 and its volatility, the gilt yield spread and the British corporate bond spread.
The pound regained 2.4% of its value versus the euro on slightly lower volatility this week, but lost 0.2% against a basket of its trading partners. The pound’s 16% loss in value since the April 2015 onset of Brexit fever is likely to contribute to the strain on household balance sheets and subsequent economic growth.
The FTSE 100 closed the week 1.3% higher on optimism over a sustainable Brexit resolution. There was also a slight dip in volatility.
The bond market quickly repriced its assessment of the threats to economic stability and growth, pushing the yield on 10-year gilts to 0.7%, an increase of 26 basis points for the week. The yield curve’s inversion signals a potential slowdown in growth in the months ahead. The corporate market kept up with the gilt market’s optimism, with the spread over gilts flat on the week.