BOE: All priced in and nowhere to go?

Investors hoping for another “get out jail free” card from the Bank of England tomorrow are likely to be disappointed. Expectations for a cut in interest rates are close to 100% and the collapse in gilt yields since the UK’s referendum highlights the belief that UK rates are now set to remain low for much of the next decade.

In the context of some of the largest declines in UK survey data seen for 20 years, any concerns about inflation, such as that due to the decline in sterling, are likely to be completely ignored by UK policymakers. The concern within the central bank will be on a slowdown turning into a major recession. The UK remains one of the world’s most leveraged nations with a large fiscal deficit and can ill-afford such an outcome.

For both the outlook for the economy and UK asset prices, we believe investors should therefore pay close attention to Mark Carney’s comments on the desirability or otherwise of negative interest rate policy (NIRP). We would be disappointed to see another central bank head emphasise NIRP over balance sheet expansion. In an environment where the change in bank lending has become such an important factor in the near-term direction of the economy, a policy which would depress banks’ profit margins and for many consumers only increase the incentive to save seems counter-intuitive.

Once interest rate policy is perceived to be exhausted the only other option (other than the highly unlikely option of doing nothing) for the BOE is to expand the size of its balance sheet. Balance sheet expansion has the benefit of being associated with higher economic growth post-2008, even if this growth has often proved transient. An open-ended commitment may be necessary to ensure that expectations do not become self-defeating; a successful policy would aim for gilt yields to be on a rising trajectory and a yield curve normalisation, to match the Bank’s longer-term inflation and growth ambitions.

To achieve rising yields while the BOE is buying bonds would require a significant increase in the supply of gilts. We doubt whether there has been sufficient time for the UK Treasury to formulate a plan in this regard but believe over the next year targets for the fiscal deficit may be de-emphasised as the Treasury may have to offset declining private sector activity with government spending due to the uncertainty of Brexit. None of this will flatter the UK’s debt/GDP position but may be deemed the lesser of the two evils in the circumstances.

The second consideration in terms of the expansion of the BOE’s balance sheet is the type of assets that will be eligible for purchase. “Pure” QE would only target government bonds while “credit easing” would also target bank lending and corporate bond markets. It is however not obvious to us that there is a lack of credit availability at present or that the price of credit is too high. To the contrary, the cost of corporate credit is already close to an all-time low and it is the private demand, rather than supply, for credit which is possibly deficient and outside the BOE’s direct control.

In our view relatively high equity valuations make direct equity purchases unlikely as present as these appear to be furthest removed from the real economy and politically very controversial.

Quick conclusions

1. At its August meeting we expect the Bank of England to match market expectations by cutting interest rates.
2. We believe markets will disappointed unless further QE and/or credit easing is clearly back on the agenda, even if these policies are not implemented immediately.
3. We would be cautious if there are any signs the BOE places NIRP ahead of balance sheet expansion to stimulate the economy.
4. It may sound radical but ever declining bond yields create deflationary expectations. A commitment to expand fiscal policy and the supply of gilts may be necessary to reverse the Brexit-linked decline in private sector expectations and investment. However, this is a decision for government and it would be unrealistic to expect any announcement at present.