Contagion

The Brexit vote means that European banks' stinginess in issuing credit will become even stingier. Realise that banks are already inundated with reserves, so there is very little more that the ECB can do.

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The problem is not a shortage of liquidity, the problem is a shortage of equity capital and profitable lending opportunities. With share prices and profitability under further pressure, banks will now make only the safest and most profitable loans.

Of course, bank lending is also about credit demand. The lingering uncertainty about the future relationship between EU and the United Kingdom will inevitably weigh on European investment and big-ticket spending. Even if Brexit is an opportunity, as some people claim, that is only true once the rules of future engagement are established. Which is months away, at an absolute minimum.

Even before the Brexit vote, Europe's 6-month credit impulse was fading. Post the Brexit vote, expect the downtrend to continue. The U.S. 6-month credit impulse has also rolled over (Chart I-6). This is highly significant because the 6-month credit impulse is the very best leading indicator of economic activity in the subsequent 3-6 months.

On the face of it, the implication is that the coming months should continue to be bond friendly. The problem is that government bonds are an ugly contest. When the yield on a bond is already deeply into negative territory, it is mathematically impossible to make gains other than through currency movements.

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