Markets are in a funk in the wake of Britain’s vote to leave the EU. The British pound has collapsed to more than 30-year lows around $US1.32, global 10-year bonds are at all-time lows, and while stocks in the UK, which closed at 6338 last Thursday are only 5.6% lower at Monday’s 5982, global banks have been hammered.
Barclays is down 32% from Thursday’s close before the Brexit vote. Similarly Lloyds is 29% lower, RBS is 37% lower while the ASX-listed, and recent NAB offshoot of Clydesdale Bank, CYBG is down 29% as well. In Germany Deutsche Bank is down 19%, in the US Citigroup has fallen 13%. In Switzerland UBS is down 18%.
In Australia the four major banks are also under pressure but their falls have been much more muted with Westpac down just 5% since Thursday’s close while the Commonwealth Bank is off around 4%.
There is a palpable air of fear gripping markets as traders and investors worry that the falls in bank share prices morphs into a rerun of the Lehman Brothers crisis that then precipitated the seizure of global finance and the global financial crisis.
But this is not a Lehman re-run according to Jerome M. Schneider, Managing Director and Portfolio Manager at PIMCO.
In a note Schneider said: “The surprise outcome of last Thursday’s Brexit vote caught many investors flat-footed. Global central bankers and others charged with liquidity management, however, have merely lifted an eyebrow”.
Alert, but not alarmed.
The reason he says that is because “short-term funding market conditions prior to the vote were decidedly different than before previous events that prompted funding contagion. Central bankers had been advertising a crisis-level prophylactic toolkit, including excess funding mechanisms, quantitative easing (QE) programs and legacy swap lines for foreign exchange”.
As a result even though bank stock prices have come under pressure that has not been replicated in funding markets which means the wheels of global finance are still turning.
“Thus far we have seen little evidence of stress in indicators such as Libor, Libor/OIS (Overnight Indexed Swap) rate spreads, or rates on commercial paper (as occurred during the financial crisis of 2008 and the European banking crisis of 2011). In fact, many of these indicators have tightened over the past few trading sessions, suggestive of more normal conditions” he said.
He highlights that while front end funding spreads have widened a little “for a handful of UK-domiciled financial institutions” there has been no wider contagion.
But Schneider says he and his colleagues are watching closely for the indicators of increased stress in global funding markets which might then indicate an phase transition into a new level of crisis – something akin to an actual rerun of the Lehman induced crisis in 2008.
Schneider gave a road map of “new and refined indicators of market liquidity and stress” that PIMCO is monitoring for real-time or lagged changes in markets:
- Use of global central bank (and Federal Reserve) foreign exchange (FX) swap lines – specifically, swap/basis markets for indications of market
levels approaching the threshold of swap line usage (https://www.federalreserve.gov/releases/h41/)
- Daily use of the Federal Reserve Reverse Repo Facility
- Changes in interdealer general collateral financing (GCF) repo rates
- Movements in the Overnight Bank Funding Rate (OBFR) Index, which details fed funds and eurodollar transaction costs
- Changes on dealers’ haircuts (overcollateralization) on collateral for repurchase agreements
- Moves in short-term unsecured financing costs (commercial paper), specifically for Yankee Banks.
These are the types of indicators that bank balance sheet and liquidity managers, not to mention central banks, will also be watching for increasing signs of stress.
But as Schneider says, so far we are only in eyebrow-raising territory.
That may seem difficult to understand given the level of fear that seems to be reflected in the recent price action and market commentary. But the indicators Schneider highlights have not yet become elevated because the current crisis is very different to the crisis that was Lehman Brothers.
The lessons of Lehman
The big difference between the current market conflagration and Lehman was that when Lehman collapsed other financial institutions were unsure who was holding Lehman and other securities of doubtful repayment probability. So banks and other institutions began calling money and other investments back from these institutions to save themselves from potential losses. This in itself caused a funding and liquidity crisis and the seizure spread to other markets including credit and swap markets which in turn caused a further reduction in global banking liquidity.
Institutions failed all over the globe as a result as the crisis fed on itself.
But since the GFC central banks and banking regulators in Basel and across the globe have focussed on risk and liquidity management and enforced what many bankers felt were draconian rules on them. But global finance is currently reaping the rewards for this more risk averse stewardship.
The difference between Brexit at present and Lehman is that Britain’s vote to leave the EU is not a banking crisis. It is a politico-economic issue for the UK and the EU. For Britain specifically the unknowns around the level of economic activity that will be affected are unknown. But traders are discounting the worst case scenarios into the price of the banks and the British pound because the political uncertainty has magnified the economic uncertainty.
Whether it is the wait until September for the Tories to choose their new leader, and hence the next prime minister, or whether it is ruction in the labour party, or the Union itself with potential referendums in Scotland and Ireland, the outlook is clouded and the process of triggering Article 50 and beginning the divorce proceedings delayed.
Markets hate uncertainty and for the moment fear is filling the vacuum.
But as Schneiders colleague Mike Amey, Managing Director and Portfolio Manager at PIMCO, wrote in a separate note overnight, “Political news to date also supports the view that Brexit risk can be contained to the UK economy.”
So for now there is no reason to think this is a start of another GFC.