Investors may think equities and sterling will be the market’s focal point for either outcome of the EU referendum. But just how fixed income will react is difficult to measure, particularly as there is no historical precedent as such.
Edward Smith, asset allocation strategist at Rathbones, in his report on the referendum ‘If you leave me now’, refers back to the UK’s decision to leave the Exchange Rate Mechanism in 1992. He points out after the UK left, foreign purchases of gilts “evaporated but did not reverse”.
He believes gilts are likely to be particularly sensitive to the political uncertainty surrounding a Brexit, with general economic uncertainty placing upward pressure on government bond yields.
Mr Smith explains: “We can perform a threefold decomposition of sovereign bond yields into the expected path of real rates, inflation expectations and the term premium.
“Heightened uncertainty around Brexit affects the term premium, while expectations of a possible fall in sterling may also push up inflation expectations. The term premium has been pushed down since the financial crisis by the global savings glut and the effects of quantitative easing [QE].
“Recently we have observed term premiums tracking eurozone cyclical indicators, the latter being a proxy for the need for more QE.”
He cautions if the vote occurs during a period of positive macroeconomic performance for the UK, then upward pressure on the term premium “could be considerable”.
“However, the real interest rate component of gilt yields is likely to move in an offsetting direction, as the Bank of England offers a monetary policy response to offset or anticipate negative effects from economic uncertainty and confidence,” Mr Smith says.
Michael Matthews, fund manager of fixed interest at Invesco Perpetual, acknowledges: “It’s very difficult to identify what effect a single factor will have on what is already a volatile market.
“Irrespective of the long-term arguments for and against a Brexit, the immediate aftermath of a vote to leave the EU would involve uncertainty and therefore volatility in bond prices.”
Nikko Asset Management’s senior fixed income manager, Simon Down, and global credit manager Holger Mertens expect that if the UK does vote to leave the EU it will play out via the equity and currency markets first. “The gilt market should be insulated to some degree as a significant amount of foreign ownership is by global central banks,” they say.
The impact on fixed income markets is purely speculation, so how have bonds been reacting in the build-up to the referendum?
David Page, senior economist at Axa Investment Managers, observes credit markets have so far moved in conjunction with assessments of whether or not the UK is likely to stay in as measured by various polls.
“If we look at sterling investment-grade credit and the difference between that and US investment-grade credit, what we see is that difference has narrowed quite significantly as the chances of the UK remaining have been bid up,” Mr Page says.