Over the past few months, the Brexit discussion surfaces continuously as its outcome is sure to have profound effects on the markets. How likely is it that it will actually occur? Or not? The recent uncertainty surrounding the future of the UK has left many unanswered questions.
UBS Securities had the following comments on the Federal Open Market Committee (FOMC) and Brexit.
UBS FOMC / BREXIT Global Macro Strategy What to expect when the Fed keeps expecting
Uncertainty around the Fed outlook continues to drive the macro backdrop For markets, 2016 has looked a lot like H2 2015. Even after the recent rally, equity returns have been low relative to elevated volatility, while the trade-weighted dollar has had trouble finding direction. Tepid global growth and fears regarding China have no doubt played a role, but the biggest source of uncertainty has been Fed policy, where investors have had difficulty navigating rapidly changing hawkish/dovish mini-cycles. Weak employment data provided some relief May’s weak employment data provided some relief from what had become an increasingly hawkish Fed. But relief will be short-lived if the US employment data doesn’t stabilize and the Fed shifts back to a more hawkish stance. ..but feedback loops between the Fed and markets persist We have argued that feedback loops between equities and the Fed are key for market dynamics, and below we extend our work to a more robust framework. Equity/Fed feedback loops are likely to persist, with risk markets continuing to have difficulty developing meaningful trends.
What to do? These dynamics have made 2016 a difficult year for macro investors, and it is unlikely to get much easier. As discussed in our Top Trades note for 2016, expected returns are likely to be low and volatility elevated. We would continue to avoid large directional positions, and instead focus on portfolio combinations and idiosyncratic trades that provide strong risk-reward. Express bullish risk through long DM equities, Gold, and EUR/CHF. Express bearish risk in short EM FX, AUD, and SEK. Inflation expectations remain under pressure The environment for bonds in the US remains good, and we have argued for convergence between 10-year rates in the US and Europe (Bunds & BTPs). The Fed has less room for hikes this cycle, and each hike is effectively worth more than 25bp due to the amplified link between Fed tightening and financial conditions. Market-based and survey measures of inflation expectations continue to fall, even as oil prices and core inflation have risen. We see three possible (and overlapping) explanations which are linked to uncertainty around the outlook for monetary policy: markets perceive the Fed as being overly hawkish; the right tail of the inflation expectation distribution has been truncated; and the market has learned from persistent inflation undershooting. Signposts: US employment, the Fed, and Brexit Two key questions: will the US employment data stabilize; and for how long will the Feds modestly more dovish rhetoric last? We are focused on potential improvement in June non-farm payrolls, and the June FOMC meeting in this regard. Updated Fed forecasts and the Fed dots will be of particular importance. Our US economics team does not expect a Fed hike until September (and then they expect another in December). The June 23rd Brexit vote may be a short-term pivot point for markets, and in the run-up to it, markets are likely to remain sensitive to Brexit headlines and polls (see “Brexit Impact on the EU”).