Commentary: Why British Rates Fell on Brexit

This one is going to be short but sweet. Many of the 'very serious people' warned that an affirmative vote to leave the EU would result in higher interest rates .  Chancellor of the Exchequer George Osborned warned of higher mortgage rates.  But its almost a full 24 hours since the polls closed and the yield on the 10 year UK gilt (and bond yields globally) has plunged close to 30 basis points despite a looming S&P credit downgrade of the British government.   What gives?  Why were so many of the economic and policy elite so fantastically wrong? 

With a proper understanding of the monetary system, it was easy predict the direction in rates upon Brexit.  Because the UK borrows exclusively in British Pounds, investors understand that a nominal default on gilts is impossible. That's why nobody took the S&P threat to downgrade the UK seriously. But even so, perhaps foreign investors in gilts would worry about the pound vis-a vi their local currencies.  So they sell their gilts and receive British pounds.  Because they are worried about the pound they sell GBP for local currency on the FX market. This sends the pound lower against other currencies.  But why don't British rates rise as gilts are sold? Because the pounds which foreign investors sold on the currency market have to go somewhere.  If foreigners are selling the UK pound, its not a heroic assumption to make that the UK domestic market is being a net buyer of the pound.  Furthermore because the domestic market is taxed in GBP, it will look for GBP-denominated financial assets to invest in, and during times of stress, what's better than risk free government bonds?  So as pounds held by foreigners flowed out of the gilt market, domestic investors flooded in.  Some spooked equity investors clearly dumped stocks and bought gilts, as evidenced by the near 6 percent sell off in the FTSE and simultaneous bond rally.

Of course, if the UK used the Euro or had a fixed exchange rate, money exiting the country would have to cause interest rates to rise, as it did in Spain and Italy during the worst moments of the ongoing Eurozone debt crisis.  But in reality, the floating exchange rate regime adopted by the UK since 1992 means that pounds essentially live in the UK financial system, and "capital flight" manifests as a drop in exchange rate, not a rise in interest rates. 

The pound did take a beating last night, but its not even clear that was due to do "capital flight."  I suspect that it was due to the unwinding of bullish GBP bets made earlier in the day as it appeared that the Remain side would win.  In any event, the pound appears to have stabilized.  If the Bank of England does not adjust its policy stance, I expect the pound to appreciate in the coming weeks.  One interesting area of research for academic economists might be the phenomenon of "market dislocation."  Eg, what if foreigners sell bonds faster than domestic investors snap them up, or certain classes of investors respond to news at different speeds.  This appears to have happened in the case of the Polish credit downgrade.  Foreign investors pulled out, and the zloty took a beating.  Rates rose domestically for a few days before plunging back down below pre-downgrade levels and the zloty regained ground.  Anyway, Keep Calm and Carry On!