Thanks to recent comments from Bank of England (BoE) Governor Andrew Bailey and his colleagues on the Monetary Policy Committee (MPC), it seems to us some market-based indicators suggest investors preparing for the BoE to raise its benchmark interest rate, the Bank Rate, within the next few months. Some financial commentators we follow deem this necessary to contain inflation (broadly rising prices across the economy), which has accelerated this autumn.[i] Others take a more dour view, warning the move could choke the recovery since the BoE has also signalled that as it raises the Bank Rate it will begin unwinding its Asset Purchase Programme (APP)—allegedly a form of double-tightening of monetary policy. In our view, however, the BoE’s guidance regarding the APP outlines a beneficial approach that reduces the risk of choking the recovery as the Bank Rate rises. Let us explain.
Through the APP, the BoE purchased UK gilts and corporate bonds from banks, leaving it with approximately £875 billion worth of gilts and £20 billion worth of corporate bonds on its balance sheet.[ii] Like similar programmes globally—known collectively as “quantitative easing” or QE—it aimed to reduce consumers’ and businesses’ borrowing costs, on the theory that this would stimulate the economy. When the BoE purchased long-term gilts, it helped reduce long-term government interest rates since—all else equal—it increased demand for gilts, which raised their prices, and gilt yields fall as prices rise. When banks set lending rates, they generally base them on gilt yields, so when gilt yields fall, so do the public’s borrowing costs, overall and on average.
The BoE is no longer adding to its gilt holdings. But it is still reinvesting the proceeds from maturing gilts to keep its total holdings steady. Hence, it is still making some purchases, which we think extends the dampening effect on long-term interest rates. However, at August’s meeting, Bailey stated that “the MPC intends to begin to reduce the stock of purchased assets, by ceasing to reinvest maturing UK government bonds, when the Bank Rate has risen to 0.5% and if appropriate given the economic circumstances.” He further stated: “The MPC envisages beginning the process of actively selling assets later, and will consider it only once the Bank Rate has risen to at least 1%, depending on the economic circumstances at the time.”[iii] Presently, the Bank Rate is at 0.1%.[iv] Monetary policy institutions often set interest rates in quarter-point increments, so many analysts we follow posit the Bank Rate could reach 0.5% at the BoE’s first or second rate rise, depending on whether the MPC chooses to first set rates at 0.25%. In either case, those warning of double-tightening presume the combination of raising the Bank Rate to 0.5% and ceasing all asset purchases would be a severe economic headwind, if not the death knell for the economic recovery.
We have a different view, which centres on the yield curve—a graphical representation of a single issuer’s rates across a range of maturities from short to long. When long-term rates are far above short-term rates, the curve is steep. When they are relatively close together it is flat. Lastly, when short rates exceed long the curve is inverted. Like many economists over time, including Nobel laureate Milton Friedman, we have found that steep yield curves are beneficial for economic growth, flatter yield curves can present headwinds, and inverted yield curves are generally negative.
In our view, the yield curve’s relationship with banking explains why. Banks’ core business model is to secure funding at short-term rates (via customer deposits and other financing mechanisms) and lend at long-term rates. Their potential profit margin, known in the banking world as the net interest margin, is the difference between the two rates. As mentioned earlier, government rates influence the rates banks pay on deposits and charge borrowers, so when the yield curve is steep, it generally means net interest margins are large. We think these bigger potential profits on new loans incentivises banks to lend more broadly than they might otherwise. A flatter curve shrinks profits, which we think discourages banks from lending to less creditworthy borrowers, as lower profits generally discourage taking more risk. An inverted curve can render lending unprofitable, which we think can create a credit crunch and risks recession (a general decline in economic activity).
When the BoE purchased long-term gilts whilst holding the Bank Rate at 0.1%, our research shows it flattened the UK yield curve. Whilst the BoE’s ceasing to increase the size of its gilt portfolio means it is now buying at a slower pace, refinancing maturing gilts still technically exerts some downward pressure. If this were to continue as the Bank Rate rose, the risk of inverting the yield curve would rise, which we think would raise the risk of recession. But ceasing the reinvesting programme when the Bank Rate hits 0.5% would mitigate this, as it would allow long-term rates more wiggle room to rise alongside short-term rates. Selling long-term gilts when the Bank Rate hits 1.0%, in theory, would add modest upward pressure on long-term rates, further mitigating the risk of an inverted curve.
Now, in our experience, monetary policymakers don’t always follow their own guidance. Sometimes conditions change, and sometimes they change their minds. But it seems to us that the BoE, unlike some other global monetary policymaking bodies, is perhaps centering policy around the yield curve. If executed well, it could not only reduce the risk of a monetary policy error in the near term, but it could even help the economy grow a bit faster than it might otherwise, as a steeper yield curve could aid lending. That is just a possibility, but we think it is worth considering—particularly as it would likely lead to economic reality beating expectations, delivering UK shares a positive surprise.
[i] Source: Office for National Statistics, as of 21/10/2021. Statement refers to the Consumer Price Index, which is a broad measure of goods and services prices.
[ii] Source: Bank of England, as of 21/10/2021.
[iii] “Monetary Policy Report Press Conference,” Opening Remarks by Andrew Bailey, Governor, Bank of England, 5 August 2021.
[iv] See Note ii.
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