Brexit: A New Phase in the Global Central Bank Experiment

Brexit has turned the central-bank debate on its head. Lower bond yields signal further tests for monetary policy.

By Richard Barley

   
The idea that the U.S. and the U.K. were talking not long ago about raising rates seems almost quaint right now, with yields plumbing record lows in the wake of the Brexit vote. Globally, the exit from emergency monetary policy has rarely looked further off.

Indeed, just two years ago, the U.K. looked like it might beat the U.S. to raise rates first. Yields on two-year U.K. gilts reached a peak some 0.4 percentage points above those on U.S. Treasurys in mid-2014.

But now, with BOE Governor Mark Carney signaling action to prop up the economy over the summer, yields on gilts have plunged. The March 2018 bond yield briefly turned negative last week, according to Tradeweb, albeit outside official trading hours.

Of course, other bond markets have already been there and done that. The German two-year yield stands at minus 0.65% and its Japanese equivalent at minus 0.33%. Yields on vast swaths of these countries’ bond markets are in negative territory. The U.K. 10-year yield at 0.88% looks relatively high, even though it is historically extremely low. U.S. Treasurys can’t escape the gravity field either. The 10-year U.S. yield has fallen nearly 0.9 percentage points this year so far.

The steep decline in U.K. bond yields is still a remarkable development for a country where deflation hasn’t been a serious threat and inflation, thanks to the plunging pound, is looming.

But the challenge the BOE now faces isn’t an isolated one.

Brexit might be a vote for separation from the European Union, but global central bank policy has become very interconnected. In the eurozone, market-based measures of medium-term inflation expectations have slipped further, and analysts have cut growth and inflation forecasts. The situation is still fragile, and the ECB may face pressure to step up again. The Bank of Japan 8301 -1.35 % is facing its own tussle with a stronger yen and weak inflation.

Swings in currencies are playing havoc by redistributing those global inflationary pressures that exist.

If global policy settings loosen further, investors may judge that, even if the U.S. Federal Reserve does nothing, it represents a tightening of U.S. policy relative to other major developed-market central banks. That would be the opposite of the problem the ECB faced when the Fed held policy steady over 2014 and nearly all of 2015: eurozone monetary policy had to be loosened relative to that in the U.S.

The Brexit vote will push central banks deeper into the unknown of monetary policy. Eight years on from the Lehman crisis, central bankers insist they aren’t out of ammunition. That argument will be tested in the coming months.

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