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3 correlations between the FTSE 100 and Brexit that you need to know before investing

To those who don’t pay much attention to the FTSE 100, it might seem that when Brexit developments are positive, the market rallies, and when sentiment is negative, the market falls.

This is true at a high level, but there is a lot more to see when you look closer. At Motley Fool, we aim to understand all the nuances of the correlations between Brexit and the stock market, to ensure that our investments react in the way we want them to. 

To that end, consider these three factors.

Interest rates (correlation: negative)

If we go back to 2016, the Bank of England cut interest rates from 0.5% to 0.25% in the aftermath of the Brexit referendum. The primary reason was to limit the impact that the Leave result might have on the economy. In theory, interest rate cuts make saving less attractive for investors and consumers alike, and thus encourages them to spend or invest. 

The FTSE 100 jumped after the interest rate cut, indicating a negative correlation to the progress of Brexit. If we see trade negotiations between the EU and UK going well throughout this year, then we could see the Bank raise interest rates. In the immediate aftermath, we would likely see the FTSE 100 fall.

Currency (correlation: negative)

The performance of the British pound (GBP) since the referendum has been well publicised by the media. The pound fell 10% in a single day against the US dollar in June 2016, and the volatility has remained high. There is a correlation between the currency and the FTSE 100, largely as a result of the many exporters within the index.

When the value of the pound falls, exporters can take advantage by getting more when they repatriate foreign earnings back into the UK. The extent of the advantage for any one company depends on the percentage of that company’s earnings that come from abroad, but certainly the FTSE 100 index as a whole rallies when the pound weakens, giving a negative correlation.

Domestic demand (correlation: positive)

In economics, domestic demand refers to the degree that normal people like you and me feel positive about our current situation. The theory is that if we feel good about the economic state of the UK, we will be more likely to go out and spend money on non-essentials, take out loans, or maybe take out a mortgage. 

You might not think it, but domestic demand is a key factor for the positive correlation between the FTSE 100 and Brexit. Brexit concerns have dampened domestic demand, which has in turn hampered FTSE 100 gains (yes the market is up, but compare its gains against the US stock market).

So going forward, should trade talk be positive by both sides, domestic demand will likely improve, providing a boost to the FTSE 100 index.

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Jonathan Smith and The Motley Fool UK have no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.