Replay | About Everything with Neil Howe: Global Brexplosion


In this complimentary edition of About Everything, Hedgeye Demography Sector Head Neil Howe discusses last Thursday's Brexit vote and the broader implications for investors. "By failing to tear down and rebuild such hapless and dysfunctional institutions as the European Union, political leaders have left electorates few options other than total disruption," Howe writes.


Click here to read Howe’s associated About Everything piece.

About Everything: Global Brexplosion!

Why Brexit is a wrecking ball. And how it is rocking markets.


Editor's Note: In this complimentary edition of About Everything, Hedgeye Demography Sector Head Neil Howe discusses last Thursday's Brexit vote and the broader implications for investors. "By failing to tear down and rebuild such hapless and dysfunctional institutions as the European Union, political leaders have left electorates few options other than total disruption," Howe writes.


About Everything: Global Brexplosion! - Brexit cartoon 06.07.2016


Last Thursday's Brexit vote was high drama. In a game of sacrifice bunts, this was a grand slam. In a political universe full of evasion, compromise, and incremental process, we were able to witness a great democracy make a critical and (apparently) irrevocable choice having far-reaching global consequences.


About Everything: Global Brexplosion! - neil howe chart1 6 28


Given the magnitude of this event, this issue of “About Everything” will be longer than usual. I want to offer readers an overview of all the economic, political, and market sequelae that are likely to issue from Brexit. There are many moving parts. We will start with the impact of Brexit on the UK and then move to its impact on the rest of the world.

Brexit and the UK

On Friday, Britain was in a state of shock. Brexiteers were jubilant. The Remain Camp was sullen. Yet whatever their mood, it gradually dawned on every Briton that their nation was entering a new and challenging era. “All these people careering around with their Union Jacks, jabbing their fingers in your face,” quipped Labor pundit Alistair Campbell. “Fine, you can have that, but there’s consequences down the track you haven’t thought about.” Well, let’s think about them. Let’s think about the quadruple whammy now hitting the UK’s economy.


Whammy One: Trade Shrinkage. An island nation with an entrepot economy, the UK thrives off trade. The UK’s goods and service exports amount to 28% of its GDP—of which roughly half (14%) goes to EU members. (That’s slightly more than total U.S. exports as a share of U.S. GDP.)  A large share of this 14% is thrown into question by Brexit.


How large? No one knows. No one has any idea yet what sort of post-Brexit trading relationship the UK will be able to negotiate with the EU. One model (the Norwegian-style European Area Agreement), while minimizing trade losses, almost certainly won’t fly because it would require the UK to slavishly abide by all the EU standards and regulations the Brits dislike—only now with no voice to object. The UK is more likely to try to negotiate a totally new FTA (free-trade agreement, like the TTIP) with the EU. Or, if this fails, the UK will try to forge Swiss-style multilateral accords on individual sectors. And if all talks fail, the UK could still trade with the EU (and pay their tariffs) as just another WTO nation.


The outcome is thus utterly unclear. Even in a worst-case scenario, there will continue to be substantial trade between the UK and the EU. But even in a best-case scenario, many UK exporters will face hardships. Some will find themselves totally barred from the EU because they can no longer subject themselves to the EU’s regulatory process. Others may be forced to incur higher costs to demonstrate compliance with EU regs or to advertise, market, sell, or enforce contracts in a now-foreign economy. These costs may in turn cause global corporations to pull the UK out of their supply chains. For centuries, London (the City) has developed a reputation as a frictionless, low-cost insider and networker—able to provide top-notch financial and business services to clients all over the globe. That reputation will suffer if the UK’s financial “passport” into the EU is revoked.


Only time will reveal the bottom line. The Centre for European Reform did a careful, multivariate analysis in 2014 of the growth in UK global trade over the past 25 years. Their conclusion: Roughly one-third of the UK’s trade with other EU members can only be explained by the UK’s political integration within the EU. One-third of 14% is just this side of 5% of GDP. Sure, that has to be regarded as an upper estimate of what the UK might lose. But it’s also a really big number. Much of the recent FX fall in the pound is the market’s estimate of how much the UK will eventually need to cut its export prices and/or raise its import prices to balance its current account once it’s out of the EU.


Whammy Two: Capital Flight. The City of London (OK, along with Edinburgh, Leeds, and Glasgow) constitutes the undisputed financial capital of the EU. Fully one-quarter of all EU banking assets are managed by UK-based banks. London banks dominate the wholesale trading of euro securities. Within the EU, they account for 85% of hedge-fund assets and 70% percent of OTC derivatives trading. In FX trading and certain insurance lines, London is not just an EU leader, but a global leader.


It was once thought back in the 1990s that the UK’s refusal to adopt the euro would impair London’s financial supremacy. Didn’t happen. But Brexit? That’s another story. In no sector are EU leaders as adamant about strict regulatory and legal compliance as in financial services. From the perspective of Brussels, the trading wiles of “les Anglo-Saxons” must be closely surveilled. (Even before Brexit, for example, the EU was pushing hard on London to clear more euro-denominated trading in the Eurozone.) No way will the Eurocrats allow the City to do banking business on the continent under their own maverick rules.


And it’s not just finance. Let’s make the plausible assumption that the UK’s post-Brexit trade regime—whatever that looks like—will disproportionately injure the operations of UK-based multinationals that are partly or wholly foreign-owned. Again, these are mainly London-based firms that sell (or may want to sell) a full range of goods and services to EU customers. Consider that nearly 50% of foreign direct investment in the UK comes from other EU members. Consider as well that, under the EU’s Parent-Subsidiary Directive, these companies will no longer enjoy favorable tax treatment.


Or reflect on another fact: Fully half of all European HQs of non-EU firms (many of them U.S. firms, like Caterpillar, eBay, and Ford) are located in the UK. Typically, they choose London as a gateway for their EU operations. Post-Brexit, how many of them will want to stay? In nearly every survey, UK business managers overwhelmingly agree that Brexit will severely impact incoming FDI and foreign office location.


So let’s cut to the chase. That giant sucking sound you hear is the withdrawal of investment from the UK. According to Fortune, the London branches of five major U.S. banks are already planning to move 10,000 jobs elsewhere. According to PwC, eventual UK job losses in financial services alone will hit 100,000 by 2020. Across the board, firms are moving funds, reconsidering advisors, putting plant and office expansion plans on hold, and reconsidering their location options. There are exceptions of course. Many smaller, labor-intensive firms that export mainly outside the EU will see the fallen pound as a huge profit opportunity. They may thrive. Indeed, their success over time will put an FX floor under the pound. But for the big integrated multinationals—and certainly for financial firms—the overwhelming theme will be capital flight.


Whammy Three: Real-Estate Crash. London is not just another big city. It dominates the national economy. With 12% of the UK’s population, it accounts for 22% of the UK’s GDP. The UK’s global reputation in fashion, media, advertising, technology, law, and (as noted) business and finance is all centered in London. More to the point, nearly one-third of the UK’s three million foreign-born residents live in the London area. Many of these are highly paid professionals. Many others are wealthy emigres from all over the world who choose London as their residence of convenience.


Post-Brexit, as jobs are cut and investment is pulled, these immigrants are likely to lead the “Brexodus” out of London. They tend to be the most mobile and least attached to the UK by family or childhood. They also are the most likely to value London’s multicultural vibe, which means many will be put off by the new anti-immigrant mood of the Brexit-voting countryside. Just after the vote, London’s mayor Sadiq Khan (himself the son of Pakistani immigrants) tried to reassure London’s foreign born that “You are welcome here.” That may satisfy some. It won’t satisfy all.


In any case, the near-certain post-Brexit downsizing of the London economy comes on top of a real-estate boom that has buoyed London home and office prices over the last eight years. (It’s down a bit over the last year, but not by much.) Home prices in most of the rest of the UK are today only back to about where they were in 2007. In London, they are 40% higher than what they were in 2007.


London real-estate brokers report that demand started fading just as the odds of Brexit started rising. And post-Brexit they say that the bottom has dropped out of the market. Most FTSE 350 companies that specialize in anything related to home construction or real estate were down 20% to 30% on Friday. At long last, the London-centric UK real-estate market is blowing up in glorious fashion. This may be good news to any American looking to buy a townhouse in Chelsea. It may even bring grim satisfaction to many hinterland Brexit voters who probably agree with the Brussels regulators on this one point only: The City’s financiers are overpaid decadent scum. But it’s bad news for the UK economy, because it’s happening at just the wrong time.


Whammy Four: Paralyzing Uncertainty. Markets detest chaos. Just let me know how all of this is going to play out, traders will say, and I’ll take a position. But with everything in limbo, I’m out. Unfortunately, indefinite limbo just this side of hell is precisely what Brexit promises to deliver.


In principle, the leadership on both sides of the English Channel understands that political delay is economically destructive. At an emergency meeting on Saturday, the ministers of the EU’s six founding members, led by Chancellor Merkel, urged the fastest possible resolution of the UK’s departure. But according to the EU’s Constitution, the UK must first initiate the process by invoking Article 50 of the Lisbon Treaty. And the UK, well, the UK just can’t get around to it quite yet.


For starters, the leadership of both of the UK’s major two parties is in disarray. Pro-Remain David Cameron has just tendered his resignation as the Tory PM, which means the Tories will have to choose a new pro-Leave Tory PM (it will probably be Boris Johnson) to lead the negotiations with the EU. That will take two or three months. So Article 50 will have to wait at least until the fall. Meanwhile, Jeremy Corbyn’s leadership of the Labor Party is also up in the air. Depending on how all these top-dog issues are resolved, the House of Commons may feel they need to call a whole new election. That may delay pushing the Article 50 start button until the beginning of next year.


Oh, and did I mention that the Scottish Independence Party (SIP) has announced that they will refuse to take part in any Brexit proceedings until they are assured that Scotland will get another referendum on independence? Most Scots don’t want to leave the EU. And what about Northern Ireland? They don’t want to leave the EU either. (London, Scotland, and Northern Ireland voted for Remain; every other region in England and Wales voted for Brexit.) So the new PM may have to tell Brussels, s’il vous plait, we may need to resolve this minor matter of the total dismemberment of our nation before thinking really hard about Brexit. No timetable possible here.


But let’s be optimistic and assume that all the secession questions can be bypassed. Even then, another knotty timing issue arises—a sort of prisoner’s dilemma problem. Each side (UK and EU) knows that both sides would benefit from a quick resolution. But each side gains for itself by holding out until the other side makes concessions. Because the UK is the smaller party, it has most to gain by delaying.


What the UK wants to gain is very simple: a generous new FTA agreement that would grant it close to the same trading rights it has now—but without the need to comply with all those EU decrees it doesn’t like. Some EU commissioners, in fact, are worried that the UK may never actually invoke Section 50, and keep trading as before, but meanwhile have Parliament start striking down all the objectionable EU laws. The EU would then have to find some way to penalize the UK for its flagrant treaty violations. It could get really ugly.


But again, let’s be optimistic. Let’s assume that the two parties complete their negotiations within the two-year window envisioned by Article 50. So we’re looking at, say, January 2019 for all the final signatures. Would that be the end of it? Almost certainly not. Most scholars agree that a negotiated agreement would only settle the basic framework. Further negotiations lasting perhaps through most of the 2020s would be needed to disentangle Brussels and Westminster in every area of trade, finance, law, and security. Who knows? These negotiations may outlast the EU itself.


One last point. We’ve looked at these four areas—trade, investment, real estate, and uncertainty—in their basic order of causation. It’s the certain prospect of huge changes in the UK-EU trading relationship that gives rise to all the rest. But their timing in markets is just the reverse. Uncertainty is what initially motivated traders to sink the pound and move drastically risk-off since the vote. We’ll see the UK real-estate downdraft and personal capital flight play out over the next few weeks. Still later we’ll see changes in business investment. Fundamental shifts in trading patterns will show up last. Economics moves from policy changes forward. Markets move from expectations backward.

Brexit and the EU

On the day after the Brexit vote, many were surprised that the biggest stock market declines weren’t in the UK (FTSE 100 down 3%). They were in all the other non-exiting EU member states (most of them down well over 6%)—making this truly a negative-sum divestiture! To be sure, much of this difference is explained by the plummeting pound, which drained value from UK firms through FX markets rather than through the bourse. But the basic question is worth asking: Why are EU markets so traumatized by the departure of a member that constitutes only 17% of EU GDP?


One reason is that the UK runs a large trade deficit with the continent—meaning that it buys a lot more from the other EU members than it sells to them. Germany alone runs a $30 billion surplus with the UK. Seven EU members (many of them in central Europe) run a surplus over 1% of GDP. Hungary may specialize in scientific equipment. But only the UK can transform that export into a product and sell it through global supply chains. Now let’s see how well all this works with the pound down 10%. Ouch!


Another reason is that EU banks, and EU financial institutions in general, are doing poorly—weighed down by nonperforming loans and squeezed by Mario Draghi’s negative interest rate vice. EU finance ministers in Brussels may not trust the London financiers—but can EU corporations really keep functioning without them? Unclear. In Germany, there is some hope that Frankfurt, Hamburg, and Berlin can steal some of London’s banking business. Elsewhere, there’s not a lot of optimism. The EU’s continental members, moreover, are a lot closer to stall speed and possible recession than the UK is. The Eurozone may not be able to absorb a body blow, which puts extra risk on the downside for firms. (Japan, where the Nikkei plunged 9% on Friday, is also navigating near the macro edge.)


Yet the biggest reason why Brexit is setting off so many klaxon horns on the continent is frankly political. The EU leadership is deathly afraid that the UK example will spread like a contagion among other members. Few EU electorates have ever had a clear opportunity to vote on the current EU constitution. And today, with Eurosceptic parties steadily gaining strength, the voting public in several countries (including Greece, France, Spain, Germany, the Netherlands, and Sweden) express roughly the same level of disapproval of the EU as voters in the UK. Marine le Pen of France’s National Front (who now dubs herself Madame Frexit) is celebrating the UK referendum and is suggesting that France’s turn will be next. Other Eurosceptic leaders are similarly congratulatory, including the Italian 5-Star Movement, the Dutch Party of Freedom, the Austrian Freedom Party, the Danish People’s Party, the Swedish Democrats, and the German Alternative für Deutschland.


This poses a dilemma for Chancellor Angela Merkel, President Francois Hollande, and the other heads of the European Council. If they were just thinking about the health of their own economies, they would gladly give the UK vast concessions in order to quell the crisis quickly and get the global economy back on track. Merkel in particular has to be worried (as every German leader is) about her economy’s export performance. Yet if everyone knows that the UK can get a good deal, then the floodgates of Frexit, Nexit, Spexit, Auxit, Grexit, and all the rest would surely follow. So the EU figures it must be conspicuously severe with the UK for its decision to leave.


As Voltaire once wrote with his usual touch of irony (after the court martial and execution of a British admiral following his defeat in battle), some must be punished “pour encourager les autres.” In another context, the Austria-Hungarian empire was once said to be a “prison of nations.” The EU leadership caste is apparently trying to enforce a similar regime. In other words, yes, it’s important that the UK suffer—and that it is seen to suffer.


It’s revealing that the equity crash on Friday showed much steeper losses for Spain and Italy, over 10%, than for the rest of the EU. Nation by nation, the market is clearly tagging political risk. It’s also revealing that the main goal of Italy’s anti-EU 5-Star Movement is not so much to leave the EU as to set up a new (and presumably devalued) currency for southern Europe. Facing the united opposition of Germany and France, however, it won’t be long before Italy too (both left and right) opts for outright exit along with the others. As for Spain, Sunday’s election showed most of the electorate veering toward the conservative People’s Party and veering away from a confrontation with the EU. Yet Spain remains deadlocked, with no side able to form a clear majority. Podemos, Spain’s new youth-led populist party, is the first Eurosceptic party since Syriza in Greece to challenge Brussels directly from the left.


We will learn in the next few months how rapidly the anti-EU rebellion grows or fades. If it keeps growing, there is nothing this time that ECB President Draghi can do to quell the threat. One never knows: Being Italian, he may in time join it.

Brexit, the United States, and the Rest of the World

With investors worldwide fleeing risk in favor of safe-haven assets, the prices of precious metals and sovereign debt are rising almost everywhere. As the VIX climbs, so do credit spreads.  And in the ultimate safe haven of the United States, the dollar is surging against nearly all other currencies while the 10-year Treasury yield is plummeting (to under 1.5%), a historic all-time low.


If we know anything about Janet Yellen and her data-dependent Fed, we know how it will respond to these developments: by swearing off any thought of hiking interest rates. According to the FedWatch Tool, the market is now writing off almost any chance of a Fed rate hike for at least the next year. In fact, there is a greater chance (7%) of a rate cut back to 0-0.25% over the next two quarters. If the Bank of England decides, as many expect, to cut its rate to 0-0.5%, Governor Mark Carney may personally ask Yellen to ratify the cut by joining him.


Yet at this point any course of action by the Fed is fraught with danger. If the dollar stays elevated and credit spreads keep widening, Yellen will have two major worries.


One is the continued health of the U.S. economy. A higher dollar will further hammer exports, causing real pain among U.S. manufacturers which (according to the BLS, ISM, and the five regional Fed surveys) have already been losing employment continuously over the past 12 months. Can services and retail continue to do all the heavy lifting? A higher dollar will also devalue overseas earnings, pouring more red ink into S&P 500 earnings statements already on track to show (in Q2) five consecutive quarters of earnings decline. Ever-thinner profit margins will discourage both investment and employment.


The other worry is the health of the commodity-exporting emerging market economies, especially those laden with dollar-denominated debt. Or forget health: We’re just talking about avoiding crisis—in Turkey, South Africa, Malaysia, Russia, Indonesia, Thailand, and a slew of Latin American economies, none of which were in very good health to begin with. A rising dollar and widening credit spreads will strangle these economies, especially if they are accompanied, as they usually are, by declining dollar prices of their primary exports.


The Fed could decide to cut rates back down to zero. But this too comes with worries. First of all, what if the Fed cuts and nothing much happens—to the dollar, interest rates, or equity markets? Then the Fed has further sacrificed its credibility (assuming there is much left to sacrifice) for nothing. Yellen may want to be a bit daring and combine a rate cut with a new round of QE. This sort of shock and awe will surely get the markets’ attention. And it may, at least temporarily, smash down long-term yields, jag equities, and reflate the dollar. But this too comes with a downside. As we become more dollar-competitive, the UK and the EU—which may by this time be teetering on the edge of recession—become less.


It’s becoming ever more obvious that the Fed cannot rescue the global economy (or even just the U.S. economy) on its own. It needs help from the sort of vigorous fiscal innovation and coordinated global leadership that only Congress and the White House together can supply. But of course this year the Fed will get no such help. A lame-duck presidency and partisan gridlock have pretty much paralyzed high-level economic policy—much as they did when the global economy was plunging into financial meltdown in the fall of 2008. Remember that? Remember when Barack Obama and John McCain were debating each other while saying almost nothing said about the free-falling Dow, even as George W. Bush was busy moving out of the White House? Ready for a replay with Hillary and Donald?


The world’s leaders have blundered into this impasse through serious errors of judgment. By trying to forestall any market downturn, central bankers have exhausted the stimulus they might have been able to use at a moment like this. By failing to tear down and rebuild such hapless and dysfunctional institutions as the European Union, political leaders have left electorates few options other than total disruption. And by failing to appreciate that ordinary people prioritize identity, community, and sovereignty ahead of money, financial leaders had no inkling of what was coming. Indeed, they doctored the evidence: It now seems clear that London banks were stacking the Brexit betting odds right up to the final day—hoping that this would either change the outcome or keep FX markets “orderly” to the bitter end.


Imagine that. The world’s elite believing that everyone is motivated only by income and wealth.  This may explain why so many ordinary people are no longer listening to them.

Cartoon of the Day: A Not So Happy Hour For Bulls

Cartoon of the Day: A Not So Happy Hour For Bulls - Not last Friday cartoon 06.27.2016


Equity markets continued to tumble today as post-Brexit aftershocks continue to be felt.

the macro show

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Hosted by Hedgeye CEO Keith McCullough at 9:00am ET, this special online broadcast offers smart investors and traders of all stripes the sharpest insights and clearest market analysis available on Wall Street.

Tick-Tock. Currency Moves Show Lack of Faith In Central Planners

Takeaway: The jig is up. Investors are losing faith in central planners' schemes.

Tick-Tock. Currency Moves Show Lack of Faith In Central Planners - Central bankers in corner cartoon 04.20.2016


With the Pound getting pounded and the U.S. dollar rallying, below is an afternoon currency market checkup with a breakdown of the big movers in macro markets. Much is changing and investors are just now beginning to hold unelected bureaucrats to account for their ineffectual policies.


Tick-Tock. Currency Moves Show Lack of Faith In Central Planners - currency checkup


The obvious callout is the post-Brexit Tumble in the pound...


Hedgeye CEO Keith McCullough in a note to subscribers this morning: 


"POUND – continues to crash, down another -3.4% vs. USD to $1.32 – signaling immediate-term TRADE oversold, finally – but this crash and the bearish TREND break-down in EUR/USD keeps the super-cycle (bullish) call for USD intact. There’s #Deflation risk in that." 


The pound is down -12% versus the pre-Brexit vote high against the U.S. dollar:


Tick-Tock. Currency Moves Show Lack of Faith In Central Planners - pound 6 27


Meanwhile, the U.S. dollar index is up +3.2%, over the last five days, as investors flee European assets:


Tick-Tock. Currency Moves Show Lack of Faith In Central Planners - dxy index 6 27


... That's also why the EURUSD is down -3.6% on the dollar strength:


Tick-Tock. Currency Moves Show Lack of Faith In Central Planners - eurusd 6 27


What may be the most significant callout of the year, in currency markets, is Yen strength, a move in direct opposition to Japanese central planners' intent. The USDJPY cross is down -15% year-to-date, despite the BOJ's best efforts. In fact, Japanese government and BOJ officials met today to discuss how best to counteract Yen strength.


Tick-Tock. Currency Moves Show Lack of Faith In Central Planners - yen strength


What's happening in Japan is perhaps most emblematic of our Q2 Macro Theme, outlining the breakdown in the central planning #BeliefSystem


It's happening all over the world.


Bottom line: The jig is up. Investors are losing faith in central planners' schemes.

McCullough: Crash Goes The Pound


In this brief excerpt from The Macro Show this morning, Hedgeye CEO Keith McCullough weighs in with his unique take on the beleagured U.K. currency.

Hedgeye Guest Contributor | Wieler: Long Gold? A Post Brexit Update

Editor's Note: Below is a Hedgeye Guest Contributor research note written by Stefan Wieler for Goldmoney Insights. A brief note on our contributor policy. While this column does not necessarily reflect the opinion of Hedgeye, suffice to say, we often concur with our contributors' conclusions. In the piece below, Wieler writes "A loss in confidence in the monetary system could have a far bigger impact on gold prices than changes in real-interest rates and longer dated energy prices alone."


Hedgeye Guest Contributor | Wieler: Long Gold? A Post Brexit Update - gold cartoon 06.17.2016



In the Referendum of the United Kingdom's membership of the European Union, 52% voted for leave, causing shockwaves through financial markets and a rally in gold. Using our gold price framework, we look at the impact on the price drivers for gold going forward.


What the leave vote means for gold going forward


Against the latest polls before the referendum, and seemingly against the expectations of the City and financial markets in general, nearly 52% of the UK voters voted to leave the European Union. This has come as a massive shock to the markets, with the GBP down 8.4% at the time of writing (over 10% at some point overnight), and equity and commodity markets crashing. Gold began to rally immediately after the first results revealed that the share of leave voters have been hugely underestimated and has rallied to USD1324/ozt, a 13.6% % gain against the GBP.


While only time will tell what the eventual economic implications will be, one thing is already for sure: The reality of BREXIT is shaking financial markets at the core. Asian and European equity markets closed with huge losses, commodity prices tumbled and currency markets are in disarray. We haven’t seen market moves like this since the credit crisis.


However, as we have written before, this is not 2008 – at least not for gold. In early 2008, gold dropped from a high of $1003/ozt on March 14, 2008 to a low of $712/ozt on November 12, 2008 while the S&P 500 lost over 30%. This time the situation couldn't be more different in our view. Rather, the three core drivers of the gold price are today firmly in gold's favor, and the price outlook is skewed to the upside.


In this report we outline what the result of the vote means for gold prices going forward, using our proprietary gold price framework we have introduced last year (see Gold Price Framework Vol. 1: Price Model, October 8, 2015).


In our model we have identified three main drivers for the price of gold: Real-interest rates, central bank policy and longer-dated energy prices. In our view BREXIT will have an impact on all 3 drivers in a positive way, adding support to gold prices going forward.

Central Bank policy and real-interest rates

As a reaction to the result, central banks will likely adopt much more dovish policies. The enormous volatility caused by the vote shows that markets have been in a very fragile state all along. This means that the likelihood that the FED will be able to raise rates in July has vanished in our view and the outlook for further hikes in 2016 and 2017 is now at risk.


We have long argued that the FED will have a hard time raising rates to their desired target of 3.25% at the end of the cycle (which still is well below historical norm). Depending on the severity of the market reaction to the outcome of the vote over the coming weeks, it could well be that the FED will not be able to raise rates any further.


Real-interest rates already began to price this in, dropping to the lowest levels since 2013 and at the brink to falling into negative territory again. As a result, gold prices shot up sharply (see Figure 1).


Figure 1: USD Real-interest rates collapsed as a result of the vote, pushing gold sharply higher


Gold USD/ozt (LHS), 10-year TIPS yield, %, inverted (RHS)

Hedgeye Guest Contributor | Wieler: Long Gold? A Post Brexit Update - gold 6 27

Source: Bloomberg, Goldmoney Research


But real-interest rates are unlikely to stop here. Before the recovery from -0.9% in 2012 back to +0.8% by the end of 2015, real-interest rates had been in a steady downward trend for 30 years. Even if the FED had succeeded raising rates again to 3.25% while maintaining inflation at 2%, realized real-interest rates would have only reached 1.25% at the peak. Any monetary policy reaction to a renewed economic recession would have inevitably pushed rates into negative territory again and to new lows.


With the outcome of the referendum however, it has become very unlikely in our view that the FED can raise rates anytime soon, meaning that interest rates will be much lower at the beginning of the next economic downturn. There is now a distinct chance that they will not be higher than they are right now at 0.375%.


This means that real-interest rates will most likely make new lows during the next down-cycle. It also means that the biggest risk to the gold price, a meaningful increase in the FED funds rate, is much less likely. Hence the referendum has set a floor on the price in our view.

Longer-dated energy prices

The immediate impact of the vote was that energy prices sold off hard. But it was mainly spot prices that go hit while longer dated prices haven’t meaningfully sold off. The reason is that speculative positions in WTI and Brent were close to all-time highs before the vote (see Figure 2). These positions tend to be in the front of the curve and have pushed time-spreads well beyond what is currently warranted by inventories (see Something’s got to give in the oil market, May 3, 2016). The leave vote caused massive sell-off in risky assets, and naturally oil was hit too with front end prices down 6% overnight.


Figure 2: As speculative positions in oil where near all-time highs, front-end prices sold off sharply with the general market sell-off after the vote


Million barrels, WTI (LHS), Brent (RHS)

Hedgeye Guest Contributor | Wieler: Long Gold? A Post Brexit Update - gold 6 27  2

Source: Bloomberg, Goldmoney Research


The risk to energy prices is that in the aftermath of the vote, global economic growth slows down, which would push the clean-up of the oil market further back in time. We currently expect that global inventories peak in late summer and then decline relatively quickly. A delay in the normalization of stocks would put a lot of downward pressure on front end prices as the curve is currently already pricing in that inventories are normalized.


Importantly, the back-end of the curve (which drives gold prices) would not be affected by such a price move in the front. However, if central banks revert to more drastic measures (like NIRP in the US or more QE) and this is seen by the market as creating inflation in real assets, we expect longer dated prices to actually rise.

The unknown variables

Measureable changes in real interest rates, central bank policy and longer-dated energy prices can explain most of the changes in the gold price in the past. However, we can also think of new drivers that impact the gold price going forward, something we haven’t experienced yet. One risk is that the leave vote is the starting shot of something much bigger. The panicking reaction of the financial markets is a clear signal that the monetary foundations stand on extremely shaky ground. Nowhere is this more visible than in the European banks.


As our colleague Alasdair McLeod writes in his recent report (see Brexit is getting the blame, June 16, 2016):


“Caught in the middle of these imbalances are the private sector banks. Because of the scale of these problems, it is no longer a patch-and-mend issue, but a serious systemic problem. The European banking system has been struggling for survival ever since the Lehman crisis, reflected in the dismal performance of share prices for nearly all the major banks.”


And further:


”The other evidence of banking woes is the flight of investment capital into government bonds from cash and deposits held within the banking system, so much so that Germany’s 10-year bond now carries a negative redemption yield. The flight into tangible bonds is so pronounced, that €400bn of investment grade corporate bonds are also on negative redemption yields.


Market commentators are blaming this on fear of Brexit, but one look at the financial condition of the European banks tells us a different story. The banks must be struggling with deposit contraction on their balance sheets, fuelled by a combination of negative interest rates and systemic fears, at a time when their loan books are burdened with bad and irrecoverable debts.


It looks like the modern equivalent of an old-fashioned run on the banking system, led by the pension and insurance companies, which are becoming increasingly concerned about leaving balances with the banks.”


A loss in confidence in the monetary system could have a far bigger impact on gold prices than changes in real-interest rates and longer dated energy prices alone.

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