Surprising markets rally

Global markets responded with resilience to the surprising result of the British referendum on June 23. Although there was initial shock at the British decision to exit the European Union (EU), the recovery was quick. Equity markets took little time to move back to pre-referendum levels. The commodity markets also saw bounces, with for example, crude oil pulling back to pre-referendum levels. The impact on currency markets has been more in line with predictions. The US dollar and the yen are up, while the euro and the pound have lost ground. Indian assets have been among the best performers. The Sensex and Nifty have surged to their highest levels of 2016. The rupee has recovered from the lows it hit versus the US dollar. Domestic institutions and foreign portfolio investors seem to be optimistic about a good monsoon and about relatively fast growth in India’s gross domestic product.

Nevertheless, the global rally is a little surprising. There is broad consensus that Brexit will have a negative impact on growth. Economists expect a dip in the EU’s already-low growth rates, while the United Kingdom (UK) is likely to slide into recession. The rating agencies have lowered the UK’s sovereign rating. However, markets are responding positively to hopes of accommodative central bank actions. As the global economy slows, central banks are expected to come to the rescue by releasing more liquidity into the global system.

China has already cut rates and pushed the yuan down. Several key central bank policy meetings are due in late July, and traders are betting on dovish stances at those. For example, it is hoped that the US Federal Reserve will refrain from hiking the US dollar policy rate, despite its stated intentions of doing so in 2016. The Bank of Japan is already running a negative policy rate and a Quantitative Expansion (QE) programme. The European Central Bank (ECB) is also running a negative policy rate, and a bond buying programme, which serves as a QE. But optimists believe that the BoJ will increase the quantum of its QE to push the yen down, while the ECB is also expected to somehow find ways to enhance liquidity. The Bank of England (BoE) has an intriguing problem. Policy rates are already effectively at zero. The pound has crashed to 30-year lows. But economic contraction is anticipated. Will the BoE move to a negative rate, or initiate a QE, at the risk of the GBP going into free fall?

The Reserve Bank of India will have to respond to the actions of other central banks in its own policy review in early August. That will be Raghuram Rajan’s last review and the RBI is also widely expected to be accommodative.

Higher liquidity could surely lead to continuing bull runs in risky assets. But if the central banks don’t meet trader expectations, there could be a sudden crash. In any case, the monetary taps are already wide open and it is not clear that another round of QEs, devaluations and rate cuts will necessarily trigger higher growth. Apart from the buying of US dollar treasuries, the post-Brexit phase has also seen a lot of speculation in gold, silver and in the crypto-currency, bitcoin. Precious metals are often used to hedge fears of currency collapse and this fear factor could be driving bitcoin up as well. Despite the rally, there is underlying tension in the global markets and that tension will not abate until the central banks issue their advisories. At that stage, the fallout from the referendum will become a little clearer.

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