investment insights
Sterling: bigger worries than negative rates
Key takeaways
- Speculation about negative rates being implemented in the UK has increased in recent weeks
- In our view, the bar for the Bank of England to cut its base rate into negative territory is quite high
- Even if the Bank were to implement such a policy, we consider it would have a limited and temporary impact on the exchange rate
- As we discussed in our latest CIO Viewpoint (Stress testing British exceptionalism), we continue to believe that the key factor shaping sterling developments is Brexit.
Recent weeks have seen increased speculation that the Bank of England (BoE) could cut its official interest rate to negative territory. The trigger was comments made by several BoE officials (see here and here) that the Bank was considering and reviewing all options to stem off the economic impact of the pandemic.
Fundamentally, an imminent cut to negative rates is not our central scenario. For one, the real rate in the UK (defined as the difference between the official Bank rate and the annual change in the Consumer Price Index) is already in negative territory, underscoring that monetary policy conditions are already very accommodative. Furthermore, unless a second strong wave of the Covid-19 pandemic ensues, global economic activity will likely start recovering in the second half of the year; this appears to be the base case of BoE officials. In addition, the BoE’s chief economist Andy Haldane emphasised recently that the Bank is still in the “review” phase of all policy options – and not in the “doing” phase – meaning that negative rates are an ongoing debate as opposed to a likely immediate response.
Finally, there are plenty of question marks regarding the transmission of such a move into the real economy. First, negative rates could adversely affect banks’ profitability, reducing their ability to lend. Second, the empirical evidence shows that the recent interest rate cuts have not translated into materially lower borrowing rates, suggesting a very limited pass-through. Hence, further rate reductions may fail to produce the desired stimulatory effects. For example, the interest rate on new two-year fixed-rate mortgages has barely moved since March of this year (when the BoE cut the base rate from 0.75% to 0.10%). This is likely due to the abrupt rise in perceived risk premia: as an illustration, consider that UK banks’ credit default swaps (a measure of banks’ credit risk) spiked from 20 bps to 150 bps, and have only come down to 80 bps since (see chart 1).
That said, one cannot rule out a negative base rate over the next quarter or two. In that case, what would the reaction of the currency market be? Simply put, we believe sterling would respond negatively, but restrainedly.
First, the market is already pricing in a reduction in the base rate to around -10 bps by the end of the year, meaning that a dip into negative is largely in the price. Second, Brexit developments have been the main driver of GBP in recent years, and not monetary policy (see chart 2). It is true that sterling fell abruptly when the BoE cut rates from 0.75% to 0.10% in March. However, the catalysts then appear to have been the pandemic (the UK experienced a sharp increase in confirmed cases at the time that forced the government to impose an unprecedented large-scale lockdown) as well as developments in the funding market (the USD rose abruptly due to the dollar liquidity squeeze). We note that since then, trade-weighted GBP has appreciated by more than 5%, even though the BoE base rate has been stuck near zero.
It is our core belief that by far the main driver for sterling will be developments on Brexit. This issue has deeper fundamental and structural implications than a mere cyclical dynamic (like rate fluctuations due to the impact of the pandemic). We retain the view that the UK and EU will manage to design a basic deal by the end of the year. This should prove supportive of sterling. However, as we discussed in our last FX Monthly, the risks of a “no-deal Brexit” (i.e. the UK defaulting on WTO rules) have increased. No material progress has been made in the negotiations, while PM Boris Johnson remains opposed to requesting an extension to the transition period (the UK has until 1 July to formally submit such a request).
Failure to reach a deal by the end of the year would be disastrous for the pound (and would in parallel increase the likelihood of negative rates). In such a scenario, we would see GBPUSD falling towards 1.10 or below, and EURGBP converging to parity.
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