The RSM Brexit Stress Index eased this week, as global equity markets pushed higher on news of a rapprochement among the parties in the U.S.-China trade war and anticipation of an interest rate cut by the Federal Reserve.
The composite index—which measures economic stress surrounding Britain’s impending departure from the European Union—fell to 0.16 at midday on Friday from a subdued range centered on 0.28 over the past month (see Figure 1). As equity markets recovered, the UK bond market absorbed the prospect of a manufacturing slowdown after the pre-Brexit inventory buildup.
Events in the bond market could have the most consequential impact on the U.K. economy and the markets; the gilt yield curve finally inverted as yield on 10-year gilt yields moved below three-month money market rates (see Figure 2). Given the possibility that the next U.K. leadership will make it more difficult for Britain to trade with the EU—its closest and largest trading partner (see Figure 3)—the shape of the yield curve now reflects anticipation of slower growth in both the immediate future and the long run; the money market began pricing in the still small (but growing) possibility of a Bank of England rate cut later this year in response to slower growth.
The index reading is showing slightly above-average levels of stress, but within a range of normality in terms of asset-price performance and volatility. Elevated levels of stress indicate a less accommodative climate for investment and the potential for lower economic growth in the months ahead.
Looking forward, the European Union has extended Britain’s deadline to depart from the bloc to Oct. 31, which leaves months of uncertainty as leadership of the House of Commons takes shape and the EU’s response to future government proposals become clearer.
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 lost another 0.3% of its value against the euro and 0.7% against an index of its major trading partners. The pound remains more than 5% lower in value since the local elections in early May. Volatility decreased slightly during the week.
The FTSE gained 2.2% during the week, with volatility leveling off.
The yield on 10-year gilts dropped 15 basis points during the week, the largest drop since the E.U. granted Prime Minister Theresa May an extension on March 22. The yield curve inverted with the 10-year/three-month gilt spread now at negative 8 basis points, suggesting concern for future economic growth.
Corporate spreads narrowed by 3 basis points during the week, narrowing for the fifth week in a row.