Yield Curve Movement: Risk/Reward versus Safe Haven Demand & Monetary Policy Expectations

Question

UK leaves Europe, credit rating get's downgraded. High uncertainty, higher perceived risk - based on just risk/reward, would expect yields on UK debt to increase.

They did the opposite. UK government yield curve was down at all tenors after Brexit news.

Assumption is that UK government bonds are still considered a 'safe haven' asset and so demand would have pushed price up/yield down. In addition, there seem to be expectations that the government will maintain a low interest rate environment to foster economic growth. Drop in yields following Brexit is explained.

I took a look a Finnish yields(5 / 10 year) after their debt was downgraded on June 3rd. Same thing, yields down. Whilst their economy is under strain, this example seems to contradict logic because the only major event on June 3rd seems to be the downgrade - nothing like Brexit.

Do you think it is right to assume that monetary policy / demand for safe haven assets generally have a heavier 'weight' than the risk/reward logic (worse credit rating = higher risk = higher reward needed to take that risk = higher yield) I have in my head? Is there something I am missing here?? I was expecting the opposite!!

Answer 1

You're missing something important. Sovereign credit ratings are very misleading when the sovereign can print its own money (like the UK). I would argue that every country is AAA in debt of its home currency, since its central bank can just print money to pay off the debts. There are examples when a sovereign chooses to default on its own currency, admittedly, but this is a choice. The rating agencies tend to downgrade sovereign debt in home currencies when countries' economies worsen, but I'm not sure it's appropriate. The markets tend to ignore those downgrades, as you have observed.