Relief Rally


“On second thought, let’s not go to Camelot. It is a silly place.” – Monty Python, “Monty Python and the Holy Grail”

One week on from the Brexit vote, the financial markets seemed to be of two minds. Equity markets completed a V-shaped rally from the Brexit-inspired sell-off, while bond markets spent the week rallying as well, with the yield on the U.S. ten-year Treasury bond approaching a four-year low.

For some, it was all part of the same risk-off trade. Get out of equities, get into bonds, especially those governments bonds seen as safer havens. For others, it was all just another trade, particularly in the equity markets.

As I wrote last week, Brexit does matter, but it probably wouldn’t matter much longer to traders raring to jump back in. The classic equity pattern in such crises is to duck and cover first, then if something doesn’t kill us right away, rally back. One could see traders talking impatiently about buying last Monday even as the selling continued into its second day. That’s how these things have usually played out in the short term. All that is required is a catalyst, and the combination of technical lines of support and the absence of signs of fresh new contagion are usually enough. In the event, it was more than enough.

Along the way, buyers were encouraged by further dovish words from central bankers, including the Bank of England’s talk of a rate cut,, followed by speculation of a U.K. corporate tax cut as well. The urge to rally became the urge to not get left out, became the urge to squeeze the shorts.

Concerns about Brexit are two-fold, and despite the trading rally they haven’t gone away. The first concern is over the long term implications of Brexit on both the British and EU economies. A lot of ideologically-tinged commentary has been written, but the most likely long-term effect is the traditional one of heightened uncertainty slowing business investment. For model-makers, that’s a difficult effect to quantify, even afterwards, while for markets it’s typically a difficult one to make out in the early going.

Most of that early going has been dominated by the contagion theme, one you can expect to continue. Fears of a contagion outbreak led to the Brexit sell-off, followed by the absence of (visible) contagion leading to the bounce-back. Veteran traders know better than to truly believe in the all-clear, however, because it can take more than a few days for problems to reveal themselves. If history is a guide, we are in for an extended episode of manic-depressive swings as potential problems appear and then disappear from view.

This is a holiday-shortened column, so I will sign off here with some of my usual cautions. Don’t use the short-term market swings as a guide to the reality of the situation – traders trade, and what investors and balance sheets may be up to is often entirely another matter. The rally in the bond markets is a disconcerting bit of discord, but one that may not last either. All we really know is that uncertainty has increased by a serious degree, and that it’s difficult to see how a global economy that was already on shaky legs might benefit from it. As for contagion, it is too early to tell yet – one week is neither proof nor disproof of whether something will come to pass. Watch the European banks.

We wish all of our U.S. readers a happy holiday weekend.

The Economic Beat (in holiday time)

The ISM (53.2) and Chicago (56.8) purchasing manager surveys surpassed expectations for June with decently positive reports. Regional manufacturing surveys from Dallas and Richmond were negative.

Construction spending was estimated to have fallen for a second consecutive month, while pending home sales for May fell 3.7%. These numbers bounce around, so the sharp drop-off in construction spending may prove temporary, but it bears monitoring. Personal income grew a bit less than expected in May, at 0.2%, while spending was at consensus with an initial estimate of 0.4%. The monthly sales rate for autos appears to have fallen sharply in June, another category to watch for signs of cyclical slowdown.

Looking at the coming week, it will be dominated by the Fed minutes on Wednesday and the June jobs report on Friday. Good things are expected from the latter. Factory orders are on Tuesday and the ISM non-manufacturing survey is Wednesday. Happy holidays!

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