Ticking Clocks and Financial Markets: Brexit and the OECD’s 2017 Economic Forecast
Michael Breen (Dublin City University)
Elliott Doak (Kroll Rating Agency)
The EU’s chief negotiator Michel Barnier warns that the clock is ticking. Soon we will learn more about the UK’s future relationship with the EU. As the negotiations proceed, the potential for new and unsettling information to emerge is greater. If a ‘no deal’ outcome seems likely, some investors may panic.
The survey of the UK economy produced by the Organisation for Economic Cooperation and Development (OECD) in 2017 provides us with an insight into how market participants operate when they are faced with an unprecedented event. In normal times, OECD surveys and other economic forecasts prompt little commentary. In these times, however, we know little about what the UK economy will look like when exit negotiations are finalized. With any prediction they make likely to be wrong, market participants have been left in unchartered waters. As a consequence, the possibility of a ‘no deal’ outcome is a real threat to monetary and economic stability. Indeed, its mere suggestion by the OECD in 2017 was enough to prompt a short-term backlash.
The OECD is an intergovernmental economic organisation founded in 1961 to stimulate economic progress and world trade. Its membership consists of 35 high income economies including the United States, Japan, and most of the European Union. One of its key functions is to perform external audits of its members in a process known as surveillance. This function is designed to generate pressure on members to reform their economic policies. Sometimes it suggests a complete overhaul, and in other cases it recommends minor adjustments. The organisation describes itself as committed to democracy and the market economy. Brexit is not a direct threat to either, so it can reasonably claim to be an impartial judge of British economic policy.
Market Reaction to the OECD Survey
The OECD survey published on 17 October 2017 predicted reduced growth without a successful outcome to the negotiations with the EU over a future trading arrangement. The prediction of reduced growth would not have come as a shock. More revealing, however, was the baseline assumption that such an agreement would not be reached. When the OECD produces a draft survey, a consensus must be reached by the representatives of member governments at the organization before the final publication can be released to the public. Given this fact, a ‘no deal’ assumption carries significant weight.
One interpretation of the ‘no deal’ assumption in the report is that the OECD is constrained by its larger European members, who wanted to limit the existential threat of future EU exits by making withdrawal look costly. Furthermore, the no-deal assumption was a realistic concern for the OECD’s team of economists, given the relatively slow progress between the UK and the EU negotiating teams at that time, and internal competition within the UK’s Conservative party.
Both financial markets and the media reacted strongly upon the release of the report. Sterling lost 116 basis points against the Euro over the following three days, bringing it to its lowest value in almost 6 weeks of trading. The pound dropped 45 basis points against the dollar on the day of release alone, with a net reduction of 25 over the next two days. Bond market reactions were somewhat unclear. The 10-year gilt dropped 6 basis points on the day of the report, but recovered most of this the next day. It is important to note that the gilt market is highly sensitive to any news that might indicate the direction the Bank of England will take regarding monetary policy.
In this sense, falling yields can come on the back of news that shows weaker forecasts for the economy in general, leading to less room for the central bank to increase rates. Indeed, the report itself notes that monetary policy should remain accommodative, drawing clear linkages between Brexit, the economy, and monetary policy. It is also important to note that the previous report by the OECD on the UK economy, released in 2015, had argued that the Bank of England should begin raising interest rates. This rollback in prescription from the organization highlights the extent to which it views Brexit constraining growth in the UK over the coming years.
In terms of media reaction, there was significant coverage of the report and its central message — that Brexit was going to hurt the UK’s economy. The national broadcaster, the BBC, ran the story, along with a range of other domestic and international outlets. The Financial Times focused primarily on the content of the report, and the prescription that the UK should seek a deal that leaves it as close as possible to trading terms possessed by EU members. There was much reaction to the report in the domestic political arena and the UK Treasury itself was even forced to clarify that there would be no option afforded to the public on reversing Brexit.
This is an example of how a routine political event can trigger a significant reaction if it reveals new information about the future path of the economy. The OECD’s relative impartiality may have added weight to its forecast. Nonetheless, the publication of its survey ranks among the less sensational Brexit-related political events, which include a failed attempt by Theresa May to secure an increased majority in parliament and numerous resignations among the upper echelons of the Conservative party. Yet the mere suggestion by the OECD of a ‘no deal’ outcome led to market volatility. One can only imagine the response if markets learn that a ‘no deal’ outcome is certain.
Michael Breen is an Associate Professor in DCU’s School of Law and Government and an affiliate of the Brexit Institute. His research focuses on the politics of global finance and the role of international organisations in the global economy. He is currently a Visiting Fellow at the European University Institute in Florence, Italy.
Elliott Doak is a Sovereign Analyst with the Kroll Rating Agency. He received a PhD from DCU on the topic of economic surveillance in 2018.