On June 23, 2016, voters in the United Kingdom (UK) voted to leave the European Union (EU). This is commonly referred to as “Brexit”. Although the UK only accounts for about 4% of global economic activity, Brexit is having a domino effect on US mortgage rates. Here’s why: Mortgage rates in the US are tied to mortgage bonds that trade in the bond market. Whenever uncertainty grips the financial markets, investors flock to the safety of bonds, which drives down mortgage rates. This is known as the “flight to quality” trade, and it drove down US mortgage rates in the immediate aftermath of the Brexit vote. On the flip side, whenever risk appetite returns to the financial markets, investors sell their bonds in favor of higher risk investments. This causes mortgage rates in the US to go up.
There are at least three “Brexit dominos” that global financial markets will grapple with over the coming few years as it relates to Brexit. When the market is fearful or uncertain about these three things, mortgage rates in the US will likely go down. When the market gains more confidence or clarity about these three things, mortgage rates in the US will likely go up.
DOMINO #1: WHAT WILL BE THE PLAY-BY-PLAY OUTCOME OF EACH STAGE OF THE BREXIT NEGOTIATIONS?
The European Union is basically a club of 28 countries in Europe that have signed a set of common trade and political agreements that allow them to operate as one nation for economic and travel purposes. In order to exit the EU, the departing nation is given two years to negotiate the terms of its withdrawal. No country has ever exited the EU, so this is brand new territory for all the parties involved.
The main reason why voters in the UK want to leave the EU is to become more independent of the EU’s rules. However, the EU accounts for over 50% of British trade, and the EU’s rules must still be followed if Britain wishes to continue trading with the EU. This means that the next few years will be rocky (to put it mildly) as negotiators try to please hard-liners on both sides of the aisle. The financial markets are likely to react whenever there’s a major setback or major progress in the Brexit negotiations over the next few years.
DOMINO #2: HOW WILL OTHER FREE TRADE AGREEMENTS BE IMPACTED BY BREXIT?
Populist movements in France and the United States are cheering Brexit as the first step toward unwinding the free trade agreements that underpin today’s modern economy. The stock market likes free trade because free trade makes it easier for companies to expand and make profits all over the world. Stock prices go up when free trade forces prevail. On the other hand, stock prices are likely to decline if free trade agreements begin to unravel. If this happens, it may cause another “flight to quality” in the financial markets, which would cause mortgage rates to decline.
DOMINO #3: WHAT WILL BE BREXIT’S IMPACT ON OTHER COUNTRIES AND ECONOMIES?
European consumers and businesses may hold off on certain large purchases and investments until the outcome of Brexit becomes more clear. This spending aversion could trigger an economic slowdown across Europe. Weaker European economies such as Italy and Greece are especially vulnerable to a slowdown, and more problems there could trigger a downward spiral on the rest of the continent. Also, the EU imports more from China than anywhere else. If the European economy slows down, it would have a ripple effect on the Chinese economy, which would then have a ripple effect on the rest of the world.
As we discovered during the financial crisis of 2007-2009, the global economy is very intertwined. Financial markets and mortgage rates are likely to twist and turn as the global economy deals with the aftermath of Brexit over the next few years. Contact me for further information or to get a real-time update on how Brexit is currently impacting mortgage rates.