Following a handful of underwhelming monetary announcements by the likes of the ECB, BOJ and RBA, today the BOE's Mark Carney unveiled his own version of Draghi's infamous "whatever it takes" gambit, unleashing a kitchen sink of options that went well beyond what Wall Street expected, even quasi-copying Draghi's phrasing, saying the central bank will take "whatever action is necessary" to ensure the UK economy remains strong.
To do that, in addition to the widely expected 25 bps rate cut, Carney also unveiled a £70bn increase to the BOE's QE to £445bn consisting of £60bn in Gilt purchases and up to £10bn of corporate bond purchases. In addition, the BOE guided expectations towards a further, small rate cut to "close to but a little above zero" by the end of the year, which would be its effective lower bound.
The Committee revised lower its GDP outlook by 2.5% over the next three years. In the BoE's revised outlook, weaker growth owes partly to a weaker outlook for potential output. Together with the effects of weaker Sterling, this implies a larger and more persistent inflation overshoot.
And Wall Street absolutely loved it, because in a replica of the ECB's CSPP, this time called the Corporate Bond Purchasing Scheme, or CBPS, the BOE assured that corporate bond yields would sink even lower, as per our preview last night, in the process forcing yield-chasing investors to buy even more dividend stocks and push the market to even greater highs, allowing banks to offload even more risk onto retail investors. Of course, that's not how they called it, instead DB's Mark Wall said "the breadth of the package and confidence in the capacity" while Goldman Andrew Benito said the BOE action was "a significant package of policy easing."
The BOE also opened up an additional spigot for bank borrowing with to the announcement of the Term Funding Scheme (TFS), an equivalent to the ECB's TLTRO. Like the TLTRO, the TFS also has a cost incentive – banks that at least maintain their lending levels will be able to borrow at Bank Rate (0.25%). Moreover, in an innovative second round, banks will be able to borrow more from the TFS, pound for pound against any increase in lending. Banks will have access to the TLS for 18 months. In August 2017 the MPC will announce whether this will be extended further.
The Term Funding Scheme (TFS) is designed to "avoid the risk that reductions in Bank Rate did not feed through fully to the rates faced by households and businesses", providing funding for banks "at interest rates close to Bank Rate" and "was calibrated so that any reduction in Bank Rate had a broadly neutral impact on building societies' and banks' margins in aggregate". More details on the TFS will be published later this month. While the MPC Minutes stress this as a "monetary policy measure", we view it as part of a credit easing policy which gives a financial incentive to banks' credit creation. It aims to achieve a lower spread of retail lending rates over the risk-free curve than might otherwise be expected. This forms part of focusing the policy easing on the "domestic economy" that we expected.
The corporate bond purchase program aims to achieve a similar aim, benefiting those companies which can issue into capital markets. The scheme will aim to raise such issuance over the next 18 months of the purchase program. Broadly following the approach of the ECB, the BoE has chosen to purchase investment grade non-financial corporate bonds. In the BoE's case, these are Sterling-denominated over 18 months and will total up to £10bn. Goldman said that it had not expected the MPC to specify its size and instead expected it to retain flexibility over the mix of corporate bond and Gilt purchases.
The result was a gusher of sellside compliments: "strong response, unconstrained, innovative, room for more, not alone.",
There are two other implicit policy messages in the MPC's Inflation Report forecasts. First, the Committee does not expect to lower interest rates into negative territory since, given its economic outlook, this would add to the inflation overshoot. In his press conference, Carney added that he is "not a fan of negative rates", although he was careful not to rule this out on behalf of the Committee as a whole. Second, the Committee would not welcome a significant further weakening in Sterling since the effects of weaker Sterling to date have delivered the inflation overshoot.
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Here is the summary of Deutsche Bank's take:
As Deutsche Bank says, the Bank of England "demonstrated its capacity for monetary policy action in a low rates environment. The Brexit referendum triggered the largest downward revision to UK growth forecasts since the creation of the Monetary Policy Committee and a package of complementary measures, from policy rates and QE to an unexpected TLTRO-like bank funding program, was agreed to lean against the risks.
The German bank then asks "will it work" to which it responds that "the breadth of the package and confidence in the capacity for further easing bolsters policy credibility. But as the ECB experience has shown, measures that underpin bank credit supply are less important when economic demand is deficient. What the MPC has done today is bought time. If its new forecasts are accurate – slightly more optimistic than consensus with no contraction in GDP foreseen – today’s actions will be enough to build a bridge to an easing of fiscal plans later this year. Fiscal policy could more effectively boost aggregate demand."
In other words, instead of a technical recession for the UK, the country may, assuming the ECB's QE reboot is successful work together with more fiscal spending, see a renewed growth spurt, mocking the forecasts of all those who said Brexit would be an economic disaster for the UK.
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Here are the details, as compiled from Wall Street's reaction:
- A strong response. The Bank of England Monetary Policy Committee acted more strongly than expected today. The 25bp rate cut was in line with expectations, but this came with a plethora of additional policy moves: a new GBP100bn four-year Term Funding Scheme (TFS) to aid the transmission of monetary policy at low interest rates through the banking system (an unexpected innovation); GBP60bn of gilt-based QE over the next 6 months (we had thought this would wait until September, but the pace of purchasing is about half the rate we were assuming); and corporate QE programme of up to GBP10bn (similar to the ECB and not wholly unexpected).
- Unconstrained. The MPC’s reticence at its last meeting three weeks ago was not a signal of general policy reticence in the face of a hugely uncertain event. There may not be any real data available yet on the post-referendum economy, but the survey evidence tells of a significant confidence shock that in and of itself will hit economic activity. The sooner and stronger the MPC responds, the better it can lean against the risks even if the full scale of the shock remains quite uncertain today. An insurance concept underlies the thinking. The breadth of the easing package sends a strong signal of policy capacity and optionality despite the proximity of the zero bound.
- Innovative. The unexpected element was the Term Funding Scheme (TFS). Like the ECB TLTRO the TFS will provide four year liquidity to banks. There is a cap on what each bank can borrow – 5% of the total stock of lending including mortgages versus 30% of private non-mortgage lending for the TLTRO. This means the TFS will support mortgage lending, although this makes more sense in the UK since the property market is particularly vulnerable to a confidence shock like Brexit. Like the TLTRO, the TFS also has a cost incentive – banks that at least maintain their lending levels will be able to borrow at Bank Rate (0.25%); otherwise the cost increases. Moreover, in an innovative second round, banks will be able to borrow more from the TFS, pound for pound against any increase in lending. Banks will have access to the TLS for 18 months. In August 2017 the MPC will announce whether this will be extended further.
- Room for more. No central bank ever wants to signal a lack of room for manoeuvre on policy and the MPC was no different. With the exception of the policy rate, where despite the signal of another rate cut by year-end the MPC “currently” sees an effective lower bound close to but a little above zero, each of the policy dimensions utilized today offers room for expansion, including the “variety” of assets being purchased. Mark Carney’s clear personal view is that policy rates would not move into negative territory. Other jurisdictions offer cautionary experiences. On helicopter money, Carney sees no merit, calling it a “flight of fancy”. Note, GBP60bn of gilt purchases is less than one quarter of the net issuance of government bonds since the first QE programme ended in 2012, offering plenty of scope for expansion.
- Uncertainty. It is still too early to judge the impact of the referendum on the economy. The MPC expects a low but positive pace of growth in the second half of the year. There are upside risks and downside risks and downside risks even after the policy actions taken today. The MPC’s forecast for GDP growth in 2017 is 0.8%. The consensus is about 0.5%, so there is scope for the MPC to be surprised to the downside by growth. Note, the signal of a further rate cut is contingent on the Bank’s baseline forecast being accurate.
- Not alone. Monetary policy does not have to fight the shock alone. Carney reiterated the macroprudential policy moves already announced, for example. Having taken action today the spotlight turns to the new Chancellor of the Exchequer Philip Hammond and the degree to which George Osborne’s austerity plans are going to be adjusted. Fiscal policy could more effectively boost aggregate demand. Our view is the pace of structural fiscal consolidation will ease, not that there will be outright stimulus. If the normal schedule is maintained, there will be no update on fiscal policy until the Autumn Statement in November/ December. Having acted strongly today and signaling plenty of capacity to go further, Carney has probably bought Hammond some scope to stick to that schedule.
- Where next for monetary policy ? If the data is in line with expectations, a further interest rate cut will come by year end. Our baseline expectation is this comes at the next meeting on 15 September, but the scale of today’s package means that if data are in line with the MPC’s slightly more optimistic than consensus forecasts the MPC may be able to wait until later. 3 November and 15 December are the other two meetings this year. Although the Bank says the parameters of the TFS are flexible, we think a strong negative shock would be required to tweak the structure in its first few months. Similarly, given the decision on a six month gilt QE programme, a strong negative shock would be required to escalate the plan within the next few months.
To be sure, even Wall Street had some complaints, notably the following complaint from Goldman that the BOE announcement was, surprise, not enouhg:
Corporate bond purchases of £10bn are somewhat less than we expected. In the BoE's previous Corporate Bond Purchase Scheme – which was not designed to deliver macro stimulus but instead support market functioning – the BoE had purchased around £2bn and the depth of this market has since risen quite significantly. Three other features of the scheme are noteworthy. First, the MPC notes that "purchases of corporate bonds would provide a greater boost to activity, pound for pound, than purchases of government bonds". Second, "such purchases were judged likely to have fewer implications for the financial system than additional gilt purchases". This is a similar justification for corporate purchases to the one we had suggested. Third, Deputy Governor Shafik noted that, while the pool of eligible securities currently stood at £150bn, the BoE "can expand that pool" of assets eligible for purchase.
Still: not even Goldman could bring itself to say anything bad in its conclusion: "Overall, this represents a significant package of policy easing."
Unfortunately, that's the problem, because just like the ECB's CFPP program is starting to break the corporate bond market, so the BOE is about to break the UK's own corporate bond market.
Here is BofA's Barnaby Martin explaining how the ECB's corporate bond buying is impairing the European corporate bond market, by soaking up liquidity.
Credit market liquidity has deteriorated since CSPP began
We see signs that since CSPP buying began in earnest (June 8th), credit market liquidity has actually deteriorated. Brexit has of course transpired in the meantime, but nonetheless bid-offers for investment-grade bonds have been moving higher. And the disclosure of ISINs looks to have been, paradoxically, unhelpful for liquidty as well.
As chart 1 shows, investors are already starting to have concerns over the growth of negative yielding corporate debt across the globe. Note the recent weakness in European corporate bond spreads despite equities being up…
- How has credit market liquidity fared through CSPP life? Chart 2 shows the average bid-offer spread (in bp) for investment-grade corporate bonds. We split the universe up into CSPP eligible, non-eligible (non-banks) and CSPP purchased bonds. We think that the picture shows some encouraging but also some concerning developments:
- What's clear is that the announcement of CSPP on March 10th initially caused mass confusion in the market. Bid-offers surged and liquidity deteriorated meaningfully in non-financial bonds. Yet, bid-offers remained steady in parts of the market that were expected to be untouched by Draghi (note the calm in non-eligible bid-offers).
- From March 10th until CSPP buying began (June 8th), credit market liquidity improved noticeably. Bid-offers tightened for all parts of the market as CSPP was deemed to be the policy that would rejuvenate the corporate bond market.
- But since June 8th, bid-offers have widened and liquidity has deteriorated again. True, Brexit took place on June 23rd, but nonetheless there has been a drift higher in bid-offers since Draghi started buying credit. And if anything, liquidity seems to have deteriorated further for eligible and purchased names, post the ISIN publication last week.
So while the aim of CSPP disclosure was to preserve credit market liquidity, the initial signs seem to point to something more worrying: that the ECB's dominance in corporate bond buying is in fact becoming counterproductive for market health.
We think that this will be another reason why investors will want to accelerate their movement into non-eligible parts of the credit market post the summer break. Not only are non-eligible sectors relatively attractive spread-wise now (chart 3), but they also offer an attractive combination of yield and volatility, we think, compared to CSPP purchased sectors (chart 4)