BoE and bonds: the fixed income view on the latest measures

The Bank of England announced a broad package of easing measures at yesterday’s Monetary Policy Committee (MPC) meeting, including:

• A 25bps rate cut

• £60 billion gilt based quantitative easing (QE)

• Corporate bond QE of up to £10 billion

• New Term Funding Scheme (TFS)1

The scale of these measures went beyond that anticipated by financial markets and the initial reaction yesterday was very positive with UK 10-year gilt yields closing -17bps lower on the day, sterling over -1% weaker relative to the US dollar and euro, as well as significantly tighter credit spreads.

The aggression and creativity shown by the Bank to try to get ahead of a post-referendum slowdown is impressive and such bold measures should gain traction. Consumers should respond to lower rates with the Bank’s planned response in the corporate and bank lending markets supporting the transmission of monetary policy to the real economy.

Bank of England on front foot

Moreover, in signalling the potential for a further rate cut and a willingness to expand their easing measures further, the Bank of England remain on the front foot should the economic data set for release in the coming months echo the weakness seen in recent survey data.

Co-ordination of monetary and fiscal policy also appears increasingly likely, as highlighted by Chancellor Philip Hammond when he stated, "Alongside the actions that the Bank is taking, I am prepared to take any necessary steps to support the economy and promote confidence."

In terms of further market response from here, we would observe:

• Write off central banks at your peril

Bond vigilantes 2 have been dealt a further blow, as the Bank has clearly indicated that it has not run out of monetary ammunition.

• Previous quantitative easing has not always led to lower yields

Indeed previous announcements have been met with higher yields, as markets have priced in a greater inflation premium from aggressive policy action. The bar for the rates market to price higher yields is greater this time round, as the efficacy of further QE is challenged by market participants.

• The Bank of England is clearly against negative rates

The market will test the Bank’s resolve if data deteriorates, especially as the TFS may allow the authorities to offset any negative feedback through the banks. The British pound will remain under pressure against this backdrop.

• Sterling corporate bonds will be supported

Issuance may increase to meet the new market dynamics.

• Inflation expectations will rise in the short term, which should be positive for inflation-linked bonds.

The MPC has laid bare its willingness to tolerate an overshoot of its inflation target in response to currency pass through; the change in imported goods prices as a result of a weaker sterling.

• A decision with global implications

A rate hike from the US Federal Reserve has become marginally less likely in September / December. The Bank of Japan may also need to act more aggressively.

• The reach for yield will continue

Risk premiums3 will remain supressed below fundamentally justifiable levels as central banks continue to intervene in the price of financial assets.

1. A Term Funding Scheme (TFS) provides funding for banks at interest rates close to the Bank Rate.

2. A bond vigilante is a bond market investor who protests monetary or fiscal policies by selling bonds

3. The risk premium is essentially the additional compensation an investor requires in order to take on additional risk.

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