Following the U.K.’s departure from the European Union more than a month ago, markets are bracing for a global health crisis and the accompanying supply shock. The RSM Brexit Stress Index — which measures financial and economic risk surrounding Britain’s departure from Europe’s common market – has shot up in the past two weeks from zero to 1.15 standard deviations above normal levels of implied stress.
Growing stress in the U.K.’s domestic financial markets caused by the global public health emergency around the coronavirus will require both fiscal and monetary fire power to address supply and demand shocks cascading through the global economy. We expect the Bank of England to cut its policy rate by 50 basis points on or before its scheduled March 26 meeting.
Instead of simply measuring the risks to U.K. economic growth during the months of trade negotiations to come, our stress index is reacting to a shock to the global economy caused by the coronavirus outbreak and the effects on the U.K. economy that are sure to come.
The financial markets’ assessment of the Brexit outcome was barely discernible in the first months of the year, with the value of the pound drifting slightly lower and the bond market continuing to price in the potential of trade restrictions dragging on economic growth. It wasn’t until the global equity-market collapse during the week of Feb. 28 that there seemed to be cause for alarm.
Very quickly, the yield curve sharply inverted at distressingly low levels, with short rates plummeting in anticipation of rate cuts from the Bank of England to offset the impending shock to economic growth. The yield on two-year gilts is now only 0.20%, dropping 35 basis points since Jan. 31, and 3-month T-bill rates are now 0.43%, which implies the base rate moving closer to the zero lower bound from its current setting of 0.75%.
Although the base rate at the zero lower bound suggests at least one monetary tool will have reached its limit, a recent study has found that the quicker a monetary policy tool is implemented, the greater its effectiveness. So while the Bank of England rightly kept its policy rate low and steady during the turmoil and uncertainty in the months ahead of Brexit, the repercussions from the new health crisis might be severe enough to justify a rate cut sooner rather than later.
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 U.K. corporate bond spread.
The pound has lost 3% versus the euro since the Jan. 31 starting point for Brexit, and 3% against a basket of currencies from the U.K.’s trading partners, all on higher volatility. This loss of buying power is likely to have negative implications for household balance sheets, which could drag down consumer spending in the months ahead.
The FTSE 100 has lost 8% of its value since Jan. 31 on higher volatility. This decline follows the worldwide loss of confidence afflicting the major stock exchanges.
Ten-year gilts are yielding only 0.33%, losing 20 basis points since Brexit’s start date on Jan. 31. The government yield curve remains inverted, which signals concern for both short- and long-term growth. The corporate bond market is pricing in substantially more credit risk than before the coronavirus outbreak.