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The road to re-opening or to negative interest rates

05 February 2021

Jeremy Sterngold, Head of Fixed Income

This week, the UK announced that the number of people to have received the first dose of the vaccine surpassed 10 million, a rather impressive acceleration of the rollout effort.[1] While the Prime Minister hopes that schools may start re-opening in the second week of March, he did note that it was too early to ease restrictions for now. Given this backdrop, the Bank of England met this week to discuss if they will include negative interest rates as part of their toolkit.

Little was expected from this meeting as the central bank announced an expansion of its bond purchases last November. The £150bn increase in government bond purchases is being put to work throughout 2021, further supporting the economy as restrictions continue to curtail activity. Throughout the pandemic, and even through the financial crisis of 2008-09, the Bank of England's main tool for easing policy was Quantitative Easing. In essence, this means buying government bonds, or to a much smaller extent, corporate bonds. With base rates currently sitting at an all-time low of 0.1%, and not having been above 1% since 2009, using asset purchases to stimulate the economy seemed like one of the few options available. However, given the quantum of government debt that the Bank of England already owns, namely £734bn[2], they may face future problems relying on this tool.

When the purchases complete by the end of this year, or earlier, they expect to own £875bn of government bonds and £20bn of corporate bonds. The parameters of government bond purchases are such that they are limited to buying nominal government bonds (thus excluding inflation-linked bonds) with a residual maturity of at least three years. In addition, the Bank of England does not intend to hold more than 70% of any single bond. The current amount of gilts outstanding that meet the above criteria is just in excess of £1,200bn. Relative to the £875bn target, this means that of the current available pool of government bonds, the Bank of England could own in excess of 70% of some bonds. This is only a theoretical limit as the current level of deficits that the Government is running mean that the supply of bonds is likely to increase resulting in a larger pool of bonds available.

However, it is undeniable that the Bank of England now owns so much of the bond market that using this tool in the future against unexpected economic shocks will run into the above issues. Therefore, it is logical that the debate around negative interest rates has heated up of late. If they exhaust the tool they have been relying on for the past 12 years, they will then need to resort back to interest rate policy, as the European Central Bank has done. We believe that for the time being, given the positive outlook that the Bank of England has communicated, they are seeking to prepare the banking system for a future eventuality whereby they may need a tool such as negative interest rates. While they revised down the growth outlook for 2020 given the current lockdowns, they still expect a powerful rebound later in the year. The level of broad household savings has  increased and the expectation is that when the economy re-opens, consumers will be eager to spend these savings to enjoy leisure activities. The success so far of the vaccination campaign gives them increased confidence of this outlook. However, if the new variants of coronavirus result in further lockdowns later in the year, curtailing economic activity for longer, then they may have no choice but to resort to negative interest rates.


[2] Bloomberg 

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