U.K. investors got the hint from Carney and aggressively moved to price in more rate cuts in the U.K., driving Gilt yields lower across the curve to all-time lows. Global bond yields followed suit, even in the face of recovering equity markets and some better economic data outside the U.K. (Chart of the Week).
Carney also stated that "monetary policy cannot immediately or fully offset the economic implications of a large negative shock." Not by coincidence, the U.K. Treasury last week signaled that fiscal policy will need to be loosened in the years ahead.
Easier policy settings are necessary in the U.K. given the tremendous shock to confidence from the Brexit vote, with a domestic economy that was already slowing prior to June 23. It is less clear that the rest of the world needs lower bond yields. Nonetheless, the implied easing of financial conditions from the fall in yields has lessened the downside tail risks to global growth, and growth-sensitive financial assets, from the Brexit shock. A quick reversal of non-U.K. bond yields is unlikely, though, given the anchor on global yields from asset purchases by the European Central Bank (ECB) and Bank of Japan (BoJ) and the Fed's more recent dovish turn.
The downside in yields is now limited by expensive valuations against a generally decent pace of global growth. At the same time, the upside is capped by a lack of global inflation pressures and central banks looking to take out insurance against any spillover from the political uncertainty in the U.K. by maintaining the easiest possible monetary policy. We do not recommend fading or chasing the post-Brexit bond rally; a benchmark duration stance is still warranted. But with yields on various higher-yielding sovereign bonds and spread products having also fallen, we see some opportunities for investors to lighten up on fixed income sectors with worsening fundamentals, like Peripheral European government bonds and U.S. high-yield corporates.