Fixed income managers expect hunt for yield to intensify as Bank of England mulls negative rates
The Bank of England has fuelled speculation over whether it will introduce negative interest rates in the UK by asking banks to detail how ready they are to deal with rates going negative.
The central bank has signalled its intention to keep interest rates ultra-low since the onset of the coronavirus pandemic in March, when it cut rates to a record low of 0.1 per cent in a bid to cushion the economy against the initial blow.
In August, Governor Andrew Bailey denied that the Bank planned to use negative rates, but clarified that they were in the Bank’s “toolbox”.
Other central banks including the European Central Bank, Swiss National Bank and the Bank of Japan, have been using negative interest rate policies for several years as a means of increasing liquidity in their financial markets and supporting economic activity.
Bailey has also stated that the current assessment of banks’ ability to cope with a further rate cut does not necessarily signal that it intends to go negative.
Fixed income managers are reshaping their economic outlook to take into account a potential sub-zero rates environment in the UK.
Dutch asset manager Robeco has updated its five-year base case scenarios to include a 20 per cent likelihood that the Bank of England and the Federal Reserve introduce “modestly negative policy rates within the next 12 months”.
It sees a further 10 per cent chance that the same institutions will roll out “deeply negative policy rates of up to -1 per cent” over the next few years.
“With the Covid-19 outbreak and related measures having pushed the global economy into recession, the discussion about negative interest rate policies has heated up. Central banks that have not yet resorted to such policies, including the Federal Reserve and the Bank of England, are under pressure to consider going “negative’ as well”, says Victor Verberk, chief investment officer at Robeco.
Going negative is “a Rubicon that they would prefer not to cross” at the Bank of England, says Henrietta Pacquement, head of investment grade fixed income at Wells Fargo Asset Management’s Credit Europe team. “The context is that they are really reluctant to use that tool, and that's why we're getting this mixed messaging.”
The Bank’s decision over whether to push rates below zero could hinge on the outcome of ongoing trade negotiations with the European Union, believes Pacquement.
“If we get a messy Brexit at the end of the year, that could be a trigger to go negative. Depending on deal, no deal, light deal, market volatility causing more of a dent to the economy. That's when we might get a trigger that tips the Bank of England in that direction.”
The Bank of England has recently tried to reassure markets that financial stability will not be threatened if Britain and the European Union do not reach a post-Brexit trade deal before the end of the year.
“Most risks to UK financial stability that could arise from disruption to the provision of cross-border financial services at the end of the transition period have been mitigated,” said the Bank’s Financial Policy Committee in its most recent quarterly update.
Bailey added that policy must be used “actively and aggressively” and noted that “we are by no means out of firepower...in terms of our policy tools”.
The first measure that the central bank is expected to announce is an increase in its bond-buying programme, which has so far totalled GBP745 billion.
As for negative rates, Pacquement cautions that “it’s not a tool to use lightly,” noting the effects low rates have already had on yields, with the market already pricing in a negative Bank rate by the fourth quarter of 2021.
“If you’re buying a UK sovereign bond with a maturity of two years, the yield on that is already negative. It's already -5 basis points.”
This could sink even lower if the central bank introduces negative rates, she says, highlighting examples in countries where negative rates have already been used.
“If you look at the two-year German government bond, their yield is -73 basis points. Japan has also explored negative rates and their two-year is at -14.
“One has to realise that this is a very extraordinary environment, and rates have crashed down globally,” explains Pacquement.
David Zahn, head of European Fixed Income at Franklin Templeton, says he doesn’t expect “a massive change” if the UK goes from being just above zero to slightly below zero, but says it will intensify the “ongoing look for yield”.
“If you have negative rates, you have to pay the bank to keep your money there, and so people will start shifting out towards fixed income assets that are a little bit longer in duration, and to other fixed income assets looking to get some yield.”
He points out that “at least in parts of Europe, a lot of investors are happy just to have a yield of zero, because if they're in the bank, they're paying 50 to 60 basis points”.
“We're back in that environment where people are looking to see where they can get the best yield in the market, given their constraints. So, you'll see credit continue to do well, and particularly high yield,” Zahn continues.
Pacquement agrees, saying that the low yield environment has already been “very supportive for corporate bonds” as the investment grade market “can provide a quite a bit of pick-up compared to where sovereign yields are”.
“If you look at UK credit, you can get another one and a half per cent above government yield.”
She continues: “Investors can also go down into high yield or private debt for that matter to pick up a bit of yield depending on their risk tolerance, and that's really what the central banks and governments want.”
Meanwhile, Robeco’s Verberk points out that the countries that have used negative rates are “increasingly searching for ways to mitigate their negative side effects, as the net marginal benefits of negative interest rate policies (NIRPs) seem to be diminishing”.
Critics of sub-zero interest rates argue that they cause harm to the financial institutions that economies depend on, by weakening profitability in parts of the financial sector, including banks.
Previous reviews of the suitability of negative rates in the UK have cautioned against them, given their impact “on the viability of small banks and building societies in the UK, as well as the provision of credit to the economy, given the large reliance on deposit finance from those institutions”.
“Put differently: because the so-called ‘reversal rate’ – the unobserved, theoretical rate at which an accommodative interest rate policy starts to reverse its intended effect – is rising over time, this begs the question how fashionable negative interest rate policies will be in five years’ time,” says Verberk.