Markets Were Rational, But U.K. Voters Weren't

A majority of Britons voted against their own interest. Economic models aren't built to forecast that.

It was 22 years ago this month when the U.S. was preparing for combat. North Korea's expanding nuclear weapons program prompted President Bill Clinton to order reinforcements. The administration was lining up votes in the U.N. Security Council to impose economic penalties on the Pyongyang government, which repeatedly denounced sanctions as a "declaration of war." Any investors could see what was coming. Right?

So how did markets correctly anticipate that this run-up to war would not lead to war? How did they foresee the outcomes of the Quebec sovereignty referendum of 1995, the euro crisis of 2010, the U.S. debt ceiling crisis of 2011, Scotland's vote on independence in 2014 and the Greek debt crisis of 2015? Or, if all that was so easy, how did markets fail to discern the probability of Britain voting last week to leave the EU?

This time was different. Unlike their elected officials, too many voters proved too proud to be rational. As much as an hour after the polls closed on Thursday, the pound had rallied to 1.50 from 1.48, consistent with the widespread expectation that the British people would accept the consensus view of domestic and international prime ministers and presidents, finance ministers, business leaders and economists and vote to remain in the EU. They expected the U.K. to support this outcome because it was the best outcome for the U.K. That was their mistake.

When the "leave" votes appeared to exceed "remain," markets lurched and wiped out billions of pounds, according to data compiled by Bloomberg. A lurch like that confirms that investors were surprised. Sterling plummeted a record 8.05 percent to a 31-year low.

The North Korea episode is among dozens of momentous events during the past 35 years when markets successfully calculated the odds of democratic governments finding a way to pursue peace and stability. Seoul's KOSPI Index plunged prior to President Clinton's escalated military preparedness on June 16 and rallied days before a diplomatic agreement was reached, outperforming the rest of Asia in 1994. Measured in U.S. dollars, South Korea's return was even greater, reflecting the strength of the won against all currencies.

The same prescience (or rationality) showed during Greece's last year. Doubts about the viability of the EU, the euro and Greece had persisted since the financial crisis 2007-8. The euro had declined about 13 percent against the dollar through the first five months of 2010, and predictions were widespread that the 16 countries sharing the euro were destined to fail as an economic entity, with breakup inevitable. By May 2012, the benchmark 10-year Greek bond was paying the equivalent of 30 cents on the dollar amid predictions the government would default.

Markets, which aren't ideological but do provide a daily reference of relative value, weren't buying it. The euro gained 9.4 percent in the second half of 2010 and advanced another 11.9 percent through 2015 when 19 countries accepted it as their national store of value. Last year, when another Greek government was back in the headlines reportedly on the verge of default and soon to exit the euro, the investor George Soros said Greece was going down the drain. During this time the yield on the benchmark Greek bond never got close to its 2012 low yield of 30 percent, instead fluctuating between 7 percent and 18 percent. Greek debt, protected by the shared European currency, proved to be the best investment globally from July through the end of 2015, Bloomberg data show.

Markets tend toward rationality even when elected officials are the ones threatening rash action. Throughout July 2011, the Republican-led Congress refused to raise the U.S. debt ceiling, putting the country on the brink of default. Investors were correct in assuming these lawmakers wouldn't deliver on their threat; the yield declined to 2.56 percent from 2.65 percent that month before dropping to 2.34 percent one year later. Since June 2011, investors received a total return of 18.7 percent from U.S. Treasury securities, when global sovereign debt delivered 7.1 percent, German bunds 1.8 percent and investment-grade corporate bonds 14.3 percent. Markets interpreted the Quebec referendum of 1995 and the similar one in Scotland no differently, anticipating outcomes that were rational.

But Britons' vote to leave the EU is unlike any other event in modern times. Investors didn't imagine a majority of voters choosing a result that proved unprecedented in its immediate and devastating impact on the British pound. The scope of this misjudgment, derived from a combination of complacency and wishful thinking, was revealed in minutes. While sterling suffered its biggest one-day decline since 1980 on June 24, the 8.05 percent loss was almost twice that of Sept. 16, 1992, the so-called Black Wednesday, when the Conservative government was forced to withdraw the pound from the European Exchange Rate Mechanism against a tide of speculation led by Soros. The toll of Thursday's vote on the pound was more than double any of the eight worst days since 1981, and its almost 13 percent reversal in less than a week dwarfed any of the previous currency debacles, according to data compiled by Bloomberg.


Britons' decision and the Korean crisis are bookends two decades apart during which financial markets proved most reliable as leading indicators. As the polls opened Thursday, the pound was the surest reflection of confidence that Britain would decide to remain within the EU. Sterling was the No. 2 best-performing currency among 31 actively traded currencies this year and its volatility had diminished the most of any currency from being the most treacherous a week earlier, according to Bloomberg data.

Investors still are in shock. Capitalism and free trade, which are inextricably linked to democracy in meeting the 21st-century challenges of globalization, urbanization and climate change, are under siege in Europe, the center from which international trade and markets illuminated the world. The words of Britain's Foreign Secretary Sir Edward Grey, spoken more than a century ago amid World War I, ring true today: "The lamps are going out all over Europe, we shall not see them lit again in our lifetime."

(With assistance from Shin Pei.)

(Corrects spelling of Sir Edward Grey in final paragraph.)
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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