How vulnerable is the US to Brexit fallout?

The rebound reflects a view that the economic fallout from the British vote will be modest in the US, while associated financial turbulence prompts the Federal Reserve to keep monetary policy supportive for even longer.

“The UK is going down the rabbit hole and it is hard to know where it ends up — but it is nowhere good,” said Mark Zandi, chief economist at Moody’s Analytics. For the US, however, there would be no meaningful impact on growth, he said.

For the time being, Fed officials remain reluctant to leap to sanguine conclusions about the referendum’s implications. There were already signs of slowing hiring by US companies going into the Brexit vote, and the turmoil in Europe has delivered a blow to global confidence that could be compounded if there is any evidence of a contagious spread of Eurosceptic feeling within other EU states.

Stanley Fischer, vice-chairman of the Federal Reserve Board, said on Friday that while most recent US data had been positive, the Fed had been propelled into a wait-and-see mode by Brexit.

So how vulnerable is the US likely to be to the UK vote and its aftermath?

What are the economic links?

The UK is heading into a self-inflicted economic slowdown following the Brexit vote. But for an economy the scale of the US, this on its own is not a major concern given the UK accounts for less than 4 per cent of global GDP.

US exports of goods and services to the UK account for less than 0.7 per cent of America’s GDP, meaning even a major downturn in Britain should not have serious effects for the US in and of itself. Even under a very severe scenario of a 10 per cent dive in US exports to the UK, US growth would slow by less than 0.1 percentage point, according to Goldman Sachs.

US exports chart

More worrying would be a broader slowdown across the EU, perhaps triggered by delays to corporate investment amid uncertainty over the bloc’s future shape. US exports to the eurozone account for nearly 2 per cent of America’s GDP.

However, domestic activity in the US will be a far bigger determinant of the short-term outlook than external trade, and with wage growth showing some signs of picking up there is no reason to expect a sudden collapse in US consumption.

Mohamed El-Erian, chief economic adviser at Allianz, said: “While Brexit uncertainties constitute yet another external headwind to US economic growth, this is not strong enough to derail the US economy, whose domestic drivers of growth remain solid, albeit not spectacular.”

And the financial links?

The UK and US are deeply intertwined financially, so this is potentially a more significant channel of contagion across the Atlantic. The US banking system’s exposures to the UK outweigh those to any other individual country, for example.

However, even as stock markets and currencies saw violent moves early last week, US officials were heartened to see the financial plumbing working fairly smoothly. Major central banks pledged to make dollar liquidity available, and post-crisis reforms meant investors were less nervous about the safety and soundness of banks than during the 2008 financial crash.
Credit spreads retreated somewhat during the week as equity markets bounced back, limiting the damage done by tightening financial conditions. Critically, yields on 10 and 30-year US treasuries fell to record lows as investors sharply pared their bets on short-term US rate rises in the next two years.

Chart: 10-year Treasury bonds

The latter may speak of a gloomy growth outlook, but cheaper longer-term borrowing costs will also support domestic US activity, including the steadily recovering housing market, helping to counter some of the ill-effects of the European crisis on confidence and investment at home and abroad.

“Basically the bond market is telling you the Fed will offset whatever negative impact there is going to be from this event,” said Tim Duy, a Fed watcher and professor of economics at the University of Oregon.

What about the surging dollar?

This is the channel the Fed is likely to be most anxious about. The surging greenback was at the centre of the financial turmoil seen in January and February and it has imposed a persistent drag on both US exports and inflation, which — stripping out energy and food — remains well below the Fed’s target at 1.6 per cent.
If slow global growth is further suppressed by a collapse in confidence within Europe, this could drive further gains in the dollar. This is especially the case given monetary policy in the UK, the eurozone and Japan looks set to be even looser than central bankers were previously signalling.

Chart: Dollar trade-weighted index

What is more, the Brexit vote has shaken basic assumptions about ever-deepening globalisation and western democracies’ willingness to pursue market-friendly policies, which could sap broader corporate confidence.

The upshot is likely to be Fed policy that remains on hold for even longer than markets were expecting. Officials will seek to avoid triggering a currency upsurge amid weaker overseas growth and looser policy from the Bank of England, European Central Bank and Bank of Japan. “With global interest rates even lower it makes it more difficult for the Fed to try to diverge from the rest of the global economy,” said Mr Duy.

“Absent a policy mistake across the Atlantic and/or a financial accident, the most pressing external issue for the Federal Reserve is the stronger dollar post-Brexit,” said Mr El-Erian.

“The outcome of the Brexit referendum is likely to retard but not eliminate the likelihood of a Fed rate increase in 2016.”

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