London - Bond investors are used to factoring things like economic growth and inflation into their models. They have less experience with politics, and these days political risk is crucial.
The immediate fallout of the UK’s stunning vote to leave the European Union has started to ease. But in conversations with investors, strategists and traders, one thing is clear: figuring out how to correctly price in what happens in the political arena has rarely been so important.
Bond strategists had to throw out their forecasts as yields around the world fell to historic lows following Britain’s vote to exit the European Union. A measure of future price swings for bonds, stocks, currencies and commodities surged. And the probability of “black swan” events, or those that are rare and hard to predict, soared to a record, based on prices paid for options contracts.
“You absolutely have to do more than just fundamentals analysis with the kind of geopolitical environment we have,” said Brian Singer, the head of dynamic allocation strategies at William Blair, which oversees $64.3 billion. “With Brexit, it was an astoundingly complicated issue.”
Unlike when he started out in the early 1990s, Singer now frequently relies on game theory to help incorporate political risk into his investment decisions. His team also recently hired an economist with a military background, partly for her ability to gauge shifts in geopolitical trends.
Rising stakes
The stakes are rising. Brexit has raised the possibility that other EU nations may follow suit. In the UK, the lack of a clear post-vote strategy from UK leaders of the “Leave” campaign has deepened worries over a prolonged period of uncertainty. Political risk in the euro region is at the highest since at least 2006, an index from BNP Paribas SA showed. What’s more, the US presidential vote and several other key elections across the developed world in the next 18 months mean there’s potential for upheaval to spill over into markets.
“Politics is definitely in the driver’s seat,” said Gene Tannuzzo, a money manager at Columbia Threadneedle Investments, which oversees about $179 billion in fixed-income assets. “The nationalist momentum has a lot of traction globally.”
Those same risks have also helped to fuel demand for haven assets, even as borrowing costs reach unprecedented lows. Globally, about $10 trillion of government bonds now have yields below zero, while those on benchmark Treasuries reached a record 1.378 percent on Friday. The average yield on securities in the Bloomberg Global Developed Sovereign Bond Index reached an all-time low of 0.435 percent at the end of last week.
That’s forced Wall Street analysts to re-calibrate. In January, the median year-end forecast for 10-year Treasury yields was 2.75 percent, data compiled by Bloomberg show. Now, only one estimate out of 72 is as high, and strategists see yields rounding out the year at 2.1 percent, from about 1.45 percent on Friday. US markets were closed on Monday for the Fourth of July holiday.
The same is true for Europe’s benchmark, the German 10-year bund. The median estimate has fallen to 0.3 percent from 1 percent at the start of 2016, with the high-end now at just 0.8 percent.
Brexit fallout
The fallout from Brexit has also had consequences for central bank policy - and not just in the UK. After the pound plummeted to a three-decade low and the UK 10-year gilt yield fell below 1 percent in the wake of the UK referendum, traders now predict the Bank of England will cut interest rates as soon as next month to ward off the risk of a recession.
BOE Governor Mark Carney added to that speculation by reassuring investors that the bank would likely ease over the next few months. At the same time, the European Central Bank is considering loosening the rules for its bond-buying stimulus, according to euro-area officials familiar with the discussions.
And in the US, traders have started to price in a rate cut this year. A strengthening dollar post-Brexit hasn’t helped matters and could potentially derail June’s rebound in US manufacturing.
“Brexit is important to markets in that it is a very clear symbol of the political uncertainty ahead and investors should heed the warning,” said Dan Ivascyn, group chief investment officer at Pacific Investment Management, which oversees $1.5 trillion. “We are prone to tail risk that involves more aggressive and uncertain central bank policy and its impact on markets, and politics where the existing political paradigms that we have grown used to are challenged.”
Some traders aren’t taking any chances. On June 28, the CBOE SKEW Index, which measures how much traders in the options market are willing to pay to protect against rare but extreme events, rose to the highest since at least 1990. Average prices in June were also the highest on record.
“This has been a political event that has become a market and economic event,” said Kathy Jones, the chief fixed-income strategist at Charles Schwab & Company, which manages $2.6 trillion. “There is no road map for this.”
* With assistance from Lukanyo Mnyanda
BLOOMBERG