On 18th June, the highly anticipated Bank of England Monetary Policy Committee meeting took place. Though not much has changed, the minutes gave some food for thought regarding the possibility of negative rates in the future.
Before delving into the details of last week’s meeting, I’d like to set out a brief explanation about the BoE’s role in the economy, more specifically how they operate in response to financial turmoil.
What is the MPC?
The Bank of England’s Monetary Policy Committee discuss and set regulations to meet the 2% inflation target and provide sustainability whilst stimulating growth. Committee members look at what has happened since their previous announcement and talk about what that means for inflation and economic growth, before voting on suitable action. In short, the committee meet every month to reflect on the economy and implement methods to keep inflation and the labour market in check.
What is Quantitative Easing & Asset Purchasing?
The Bank of England, amongst other operations, influence the UK’s economy by adjusting the Bank Rate. A lot of underlying, consumer-facing rates are derived directly from this alone, and the BoE’s ability to stabilise inflation and maintain a sustainable economy is reliant on the Bank Rate they set.
Quantitative Easing also referred to as Asset Purchasing, differs from the BoE’s regular operations, as it has an unconventionally large scale in place to expand monetary policy. The objectives of QE are to ease financial markets, by lowering costs for consumers entering debt obligations.
Bank Rates
One-way QE is implemented, is by lowering the Bank Rate. Immediately the BoE will pay less on their deposits from commercial banks, restricting the spread those banks receive as revenue. This creates a downward pressure that applies to other, consumer-facing rates, such as interest rates on mortgages and loans, which encourages spending. However, rates can only go down so far before the central bank begins to run out of leverage. Recently across Europe, in countries such as Switzerland and Denmark, negative Bank Rates have been introduced by their respective central banks. And so, alternative options are needed for banks to stabilise the economy, and thus we come to our second implementation of QE.
Asset Purchasing
Central banks can also turn to asset purchasing in times of need. This involves the bank using its reserves to enter open market operations, as buyers, in securities from corporations and commercial banks. In turn, the central bank increases its balance sheet by holding onto these assets. Theoretically, this process increases cash flow in the economy, and here’s why:
As mentioned previously QE is used when banks are more reluctant to lend, like in financial turmoil, when credibility of businesses are low. When the Bank Rate is already low, the banks already borrow at a relatively cheap cost, but spread on consumer facing rates such as long-term loans and mortgages, may still be high. So, by implementing asset purchasing, the banks have an increase in cashflow that if left alone, has a low return. The idea is that this will make banks more likely to loan out to businesses and consumers. And an added bonus is a great example of game theory, as competition from other, newly, cash-rich banks drive the consumer facing rates even lower. Thus, stimulating the economy.
QE can also decrease rates by lowering yields on financial assets. To maintain rigour in our explanation, the yield on an investment is the income return an investor receives, divided by the price paid for the asset in question. By buying financial assets such as treasury bills, the central bank increases its price and therefore lowers the respective yield. This makes it easier for the government to borrow money going forward, as they can now issue new bonds with a lesser yield, whilst remaining competitive. This also helps the government pursue fiscal policy and encourages more investment in riskier assets. Now the bonds are less attractive, so investors are likely to sell bonds to move into riskier corporate bonds and securities, thus boosting the volume of activity in the stock market and improving capital market conditions.
The Verdict
In retrospect, countries who chose to implement QE after the 2008 financial crisis have fared better since. For example, in 2009 the US Federal Reserve purchased $4 trillion in mortgage backed securities because investors thought they were too risky to buy. This boosted consumer confidence, allowed banks to offload those assets and issue more mortgages, thus stimulating the economy.
However, QE does present its fair share of risk. In the UK, and many other countries, there is a 2% inflation target. QE, however, can cause hyper-inflation if not implemented correctly alongside the risk that injecting cash may not actually boost business activity, as businesses and banks may not use their newfound liquidity. If institutions don’t have confidence in the economy, they may hoard the newly found cash. A great example of this is present in Japan, who now suffer deflation.
It is important to note, before we move on, QE is not intended to be permutant. As inflation rises to stable figures, QE will be reversed, the central bank’s balance sheet will unwind, and cash will be destroyed. The timing is as important as the timing of implementation in the first place.
We are yet to see countries fully reverse the methodologies of quantitative easing since the 2008 financial crisis.
Monetary Policy Committee meeting 18th June 2020
Aligned with our definition of the environment required to implement QE, the BoE explained its challenge at present is to respond to the severe economic and financial disruption caused by the spread of Covid-19. The voting on the key concepts are as follows:
- The Committee voted unanimously to maintain Bank Rate at 0.1%
- The Committee voted unanimously for the Bank of England to continue with the existing programme of £200 billion of UK government bond and sterling non-financial investment-grade corporate bond purchases, financed by the issuance of central bank reserves.
- The Committee voted by a majority of 8-1 for the Bank of England to increase the target stock of purchased UK government bonds, financed by the issuance of central bank reserves, by an additional £100 billion, to take the total stock of asset purchases to £745 billion. [1]
To summarise, the base rate was held at its record low level of 0.1% and the central bank injected another £100 billion QE into the economy taking the stock of asset purchases to £745bn.
The BoE, shortly after, addressed the risky-asset rally seen since March lows. They explained that recent data has revealed that the fall in global GDP in 2020 Q2 is less severe than expected at the time of the May Monetary Policy Report. However, this should be taken with a pinch of salt, as far as recovery is concerned.
The BoE has forecasted a 20% fall in Q1 and Q2 combined GDP vs the original forecast of 27%. This coupled with another announcement made by the BoE this week in response to stabilising liquidity conditions, stating “purchases can now be conducted at a slower pace than was necessary during the earlier period of dysfunction “, gives reason to believe last week’s meeting has revealed at least some progress has been made.
Fallout
Interestingly, Neil Birrell, chief investment officer at Premier Miton, said: “No change to rates, no surprise. The bond purchase target was increased to £745bn, up £100bn, again no surprise. There is nothing in this for markets to react to, but the increase in the bond purchases shows that central banks will keep going to the well to support the financial system and as the BoE says, it is ready to take further action if needed.” These quotes perfectly summarise what we can infer from the meeting alone.
Since then, governor of the MPC, Andrew Bailey, has supported the notion of the unsustainability of asset purchasing in the long-term, mentioned previously, by writing an opinion piece for Bloomberg titled “Central Bank Reserves Can’t Be Taken for Granted – The current scale of central bank balance sheets mustn’t become a permanent feature.” This suggests, at least if he can convince the rest of the committee, that the MPC may decide on adjusting its levels of reserves first, without waiting to increase the Bank Rate on a sustained basis.The governor’s Bloomberg article came just one month after Mr Bailey performed another U-turn, telling MPs to expect the BoE to announce the introduction of negative interest rates for the first time in history. It’s also worth noting Andrew Bailey has revealed, upon further easing of the QE asset purchasing programme, the BoE will review its corporate bond portfolio and favour assets in industries that support important initiatives such as climate change. [2]
How does this effect bond yield prospects?
This should be relatively straight forward, since the main driver of bond yields at the moment is the BoE’s involvement. Since the beginning of the Asset Purchasing Programme, the rate at which the BoE is acquiring bonds to their balance sheet is unprecedented. Relative yield on gilts have slumped due to the rise in price, and since these have become a trivially obvious investment to avoid.
Although, BoE will not be spending the additional £100 billion announced last week on anything other than government issued bonds. This dampens the rise in price of corporate bonds. However, the increased volume of interest in corporate bonds due to the unattractiveness of gilts and risky securities will still continue to support a rise in price of such assets.
How does this effect GBP and consumer purchasing power?
The Pound initially reacted positively, with GBPEUR and GBPUSD jumping higher. However, the Pound’s unique disadvantage with severe Covid-19 economic worries, pending negative rates, and Brexit creating a constant triple threat, proved too much. As a result, both GBPEUR and GBPUSD headed to fresh weekly lows, with the dollar battling 1.24 and GBPEUR at 1.1060. [3]
Since the initial reaction, the Pound endured a rough time relative to other currencies in FX. On June 29th, a rebound began, though It would not be surprising for the fundamental reasons for sterling weakness to remain in place. That being the daunting triple threat mentioned above.
However, recent comments this week emerged from the BoE’s Chief Economist Andy Haldane, that he was seeing evidence of a ‘V-shaped’ recovery, providing some surprising good news that might have helped to trigger a little more optimism. It can be argued that the FX markets have been pricing in the possibility of the BoE considering negative interest rates. The comments from Mr Haldane on Tuesday perhaps make this slightly less likely. Andy Haldane also was the only committee member at the MPC meeting that indicated he didn’t feel more stimulus was necessary. [4]
Important Data Release
Today marks July 3rd, as the latest UK Services data, a key release for the UK economy is released. This provides the latest snapshot of the largest contributor to UK growth, estimated to account for around 80% of the UK economy. Such data is crucial in determining not only whether Andy Haldane is correct in his estimations of the UK economy ahead, but also whether the pound is likely to be able to continue this current run of form, or whether it will ultimately be remaining a poor performer in the market’s eyes.
The data released this morning revealed companies in the services sector did more business in June as the government eased movement restrictions. According to Markit, the services PMI rose to 47.1 from the previous 29.0. That was in line with what analysts polled by Reuters were expecting.
It was also the third straight month of straight gains after the PMI collapsed to 12.3 in March.
According to Markit, 33 per cent of survey recipients reported a drop in business activity while about 28% of them reported growth. Similarly, the number of companies that reported a decline in businesses fell from 79% to 54%.
Further, the trend will likely continue as the country reopens bars and restaurants this weekend. In a statement, Tim Moore of Markit said:
“June data highlights that the worst phase of the service sector downturn has passed as more businesses start to reopen and adapt their operations to meet social distancing requirements. The proportion of service providers reporting a drop in business activity has progressively eased after reaching a peak of 79% in April.” [5]
We can comfortably make inferences from the services data thanks to its large share of the UK’s GDP. The data supports the notion of a V-shaped recovery predicted by Mr Haldane, though should not be taken as blind optimism.
