Focus: Brexit Turmoil, ECB Council convenes

Markets appear prepared for rejection

Rumors that a vote in the British Parliament on the separation agreement with the EU, which was then denied by the British government, could be postponed show how bad the outlook for approval is. Even if the political path there is not predictable, there are three options at the end of the road: the negotiated package could finally be accepted, the people would be questioned again (referendum or new elections) or hard Brexit. We tend towards the second scenario, since it is hard to imagine that the negotiated package would find a majority. This would require many parliamentarians to change their minds or necessitate renegotiation with Brussels. The hard Brexit scenario would have serious immediate economic consequences for the UK, for which no one would want to take responsibility.

A rejection of the separation package by the British Parliament next week should lead to no strong market reaction. The market is already assuming, for the most part, that the political process will continue at least until the end of the year. After the first vote on December 11, there is a deadline of three weeks for a second vote. If this also fails, there is still the possibility of snap elections or a new referendum, for which the EU would probably give time by agreeing to a postponement of the withdrawal date.

We assume that the outlook for a new referendum or new elections would be positively received by the markets, because then there would be at least a chance that the UK would remain in the EU. A decision on this should take place in early January, if a large majority rejects the deal next week, maybe even this year. The most likely scenario for us is that the situation in the financial markets will ease early next year and investors will become more willing to take risks again. For government bonds, this means a rise in yields. If, on the other hand, a hard Brexit should ultimately occur, this speaks for insecure financial markets until after the withdrawal date of March 29. In this case, yields would probably remain low for longer than we currently expect.

ECB Council to wait

The Governing Council of the European Central Bank (ECB) will also meet in what is likely to be a turbulent week. The monetary policy outlook should not change. Although economic and inflation data have been disappointing in recent months, the Governing Council has given itself until after the summer of 2019 to decide whether to raise interest rates. This means that there is (still) no need for a policy correction. Nevertheless, President Draghi's press conference will have a lot to offer. Draghi will certainly be asked about his assessment of the risks in a turbulent environment (Brexit, Italy, trade conflicts, volatile markets). The basis for his statements should be the new forecasts of the ECB economists. The question is what impact the latest data will have. The GDP forecasts, which were 2.0% in September for 2018 and 1.8% for 2019, are certainly subject to downside risks. These are also given for the inflation forecast, but this is certainly more difficult to assess. However, the risks for a downward revision of core inflation in the coming years also exist because the ECB had still assumed relatively high values in September.

In addition, the Governing Council will specify the distribution of reinvestments of repayments from the bond portfolio. The markets have been waiting for this for a long time and the Governing Council has postponed the decision until the last possible moment. The current rules stipulate that securities of public issuers must be reinvested in a security of an issuer of the same jurisdiction no later than three months after redemption. There are only very rough guidelines for reinvestments in securities of private issuers (corporate bonds, covered bonds, ABS). ECB President Draghi has repeatedly confirmed that the capital key will remain the benchmark for the country weighting of reinvestments. The ECB could loosen the asset class weighting. However, from our point of view, major changes are unlikely. The whole issue is likely to be of significance mainly for the above-mentioned securities of private issuers, whose redemption payments and thus future reinvestments are distributed very differently over the months. Here the ECB could create room for maneuver in order to smooth future purchases and thus the effects on the markets over time.

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