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'Surreal' market environment could focus on Brexit Thursday

Brexit could return to the forefront on Thursday, as the Bank of England meets and big U.S. banks start to roll out earnings.

The Bank of England meeting puts the spotlight back on how the U.K. will deal with the financial implications of its exit from the European Union, now that Theresa May was named Prime Minister Wednesday. Bank of England Governor Mark Carney has suggested more than once that the central bank could provide stimulus this summer to ward off a recession, and many in the markets take him at his word.

A Reuters survey of economists showed that 39 of 60 respondents expected the central bank to announce a quarter point cut to the 0.5 percent bank rate when it issues its statement at 7 a.m. EDT.

Pedestrians walk past the Bank of England (BOE) in the City of London, U.K.
Luke MacGregor | Bloomberg | Getty Images
Pedestrians walk past the Bank of England (BOE) in the City of London, U.K.

"My guess is you'll see a rate cut but you will probably not see the parameters of a quantitative easing," said Rick Rieder, chief investment officer of global fixed income at BlackRock. Economists expect the BOE to wait until August to announce a quantitative easing asset purchase program, but Rieder said Carney may discuss the other tools he has available.

"I think the markets are anticipating a description that they will do more if necessary, and if there is not rate cut you could see a back-up in yields in the U.S.," Rieder said.

U.S. Treasurys gained Wednesday, halting this week's decline, and yields fell as a result. The 10-year note was yielding 1.47 percent late in the day, while the 30-year yield was 2.17 percent. The demand at Wednesday's $12 billion 30-year bond auction was the strongest since September, a stark contrast to the weak 10-year note auction the day earlier.

Stocks were mixed, with the Dow up 24 points at a new record close of 18,372, and the S&P 500 also reached a new high, rising less than a point to 2,152.43. The Nasdaq was lower, off 17 at 5,005.

Bonds will continue to be a focus Wednesday as the stock market also absorbs the first of the major financial companies' earnings; JPMorgan Chase and BlackRock both report before the opening.

JPMorgan is expected to earn $1.42 per share on revenue of $24.2 billion, according to FactSet. Wells Fargo and Citigroup report Friday, and Bank of America reports Monday.

"I'm hopeful it will show the U.S. banks have been pretty much impervious to the vagaries of Europe," said Jack Ablin, BMO Private Bank CIO. "I think that's an important thing, but it will be interesting to see what JPMorgan has to say about their London capital markets operation."

U.S. banks are widely expected to move some operations out of the U.K., as a result of the split between Britain and the EU.

Besides earnings, there are weekly jobless claims and PPI inflation data, both due at 8:30 a.m. EDT. Three Fed speakers are on the circuit Thursday, including Atlanta Fed President Dennis Lockhart at 11:15 a.m.; Kansas City Fed President Esther George at 1:15 p.m. and Dallas Fed President Rob Kaplan at 7 p.m.

There are more than a dozen Fed speeches in total this week, and so far there is no sign that the Fed would like to alter the slow pace of rate hikes. Markets anticipate one rate hike at the most, and the Fed still forecasts two. Philadelphia Fed President Patrick Harker on Wednesday said the Fed could hike rates up to two times before year-end, a change in his call of two to three hikes made before the Brexit vote.

If the Fed wants to alter the market's view on rate hikes, economists have noted it could do so when it meets later this month. The July 27 meeting is not seen as a likely time for a rate hike, but September and December could be. However, chances are seen as slim for September.

"I'm going to hold to the case that this Fed is going to have a hard time moving this year. That being said, I think the Fed would like to get a rate hike in and the question is are you going to get the opportunity to do it, but I think the dynamics made it significantly more difficult," said Rieder.

Rieder, who believes the Fed should have raised more aggressively in the past, said the central bank now had to worry what impact its actions, including triggering a move higher in the dollar, could have on the rest of the world.

"Fifty-five to 60 percent of growth is coming from emerging markets. If the dollar was going to rise significantly, it could impact that growth," he said.

If the Fed does hike this year, it would more likely be in December, rather than at its September meeting, he said. But he said this would mean Europe would have to settle down and China look more stable. "I think they could go in front of the [U.S.] election. That said, the bar is very high, and not because of the election," he said.

He said the historically low rate environment had a "surreal" feel, while it had driven strong appetite for corporate bonds and other instruments. The 10-year Treasury yield, in a range between 1.55 to 1.85 percent before the late June Brexit vote, could now see as much as a 25 basis points-move below that range, he said.

"If there's any significant negative news or shock risk, that will take you to the lower end of the range. I think demand will continue to come in for yield and income globally and domestically," he said. Longer duration Treasurys and corporate bonds have become the securities of choice in recent sessions, as investors from around the world compare U.S. yields to the many negative and super-low yields available elsewhere.

Ablin said the historically low rates were sending ripples through the stock market, and creating confusion for investors. Dividend stocks in telecom and utilities were again the top performers.

The move to negative yields in Japan and Europe has turned some rules of equity investing upside down, as investors try to secure some yield, he said. The European Central Bank also started buying corporate debt ahead of Brexit, which only fueled debt issuance, which helped companies buy up more of their stock, he said.

As for stock investors, they are climbing aboard dividend plays.

"If you're buying stock with a solid dividend that will either maintain or grow, what do you care what the stock price does, you just want to make sure the dividend will be there through thick or thin. The good news is dividends have had a long track record of staying ahead of inflation. From that perspective, it makes sense, but there may be buyers who don't care what the stock price does. Unfortunately the rest of us do," he said.

Ablin said traditionally the 10-year Treasury yield had been higher than the S&P 500 yield but that was no more.

"There was a period in 1955 when bonds yielded less than stocks. But for the most part, bonds offer higher yields than equities so as a result, anyone looking for income for retirement didn't have to think twice about what a retirement portfolio should look like," he said.

The hunt for yield explains why investors could see record high stock prices, while at the same time yields are at historic levels, Ablin said.

"To me it doesn't seem like the type of market where you want to stick your neck out too far," he said.

Brexit and the actions of central banks were behind the super low yields, and a move by the BOE could continue to fuel the extreme market moves, he said. "Lowering interest rates there is just going to make the pound go lower and fuel the dollar," Ablin said.

"Right now, I would say the U.K. market's on sale. The price of a latte in London is now on a purchasing power equivalent basis, more like a latte in New York. It hasn't been like that in 30 years. The British pound is actually fairly valued," he said.