The Bank of England’s (BoE) decision to cut rates, expand its bond buying and set up a new funding scheme for lenders is a proactive policy response to the EU referendum. But it is only likely to cushion, rather than fully offset, the shock to UK growth that June’s Brexit vote will cause, Fitch Ratings says.
The balance sheet expansion goes beyond our expectations and includes innovative measures to mitigate potential unintended consequences of policy easing.
The BoE cut the base rate to 0.25% from 0.5% – the first change in over seven years. It will expand UK government bond purchases by GBP60bn, and will purchase up to GBP10bn of UK corporate bonds. The BoE also announced a new Term Funding Scheme (TFS) aimed at ensuring the base-rate cut is passed through to borrowers.
We incorporated lower rates into our post-EU referendum update of our UK macro-economic forecasts, cutting our end-2016 policy rate forecast to 0.25% from 0.75%.
The BoE had already reduced the counter cyclical capital buffer for UK banks. Combined with a rate cut and increased quantitative easing, such measures forestall the risk of a significant tightening in credit conditions that would compound the impact of the Brexit vote.
But they will not outweigh the impact on investment as firms reduce capital spending due to sharply heightened uncertainty surrounding the UK’s future international trading arrangements outside the EU and related political and regulatory uncertainty. We expect investment to be 15% lower by 2018 relative to our May forecast.
The referendum will take a significant toll on the economy despite sterling’s fall potentially supporting exports. This is reflected in our latest growth forecasts of 1.7% in 2016 (down from 1.9% in May) and 0.9% in 2017 and 2018 (from 2.0%). The BoE’s assessment suggests sizeable concerns about the near-term outlook as a number of survey-based indicators have deteriorated dramatically. They are now forecasting 0.8% GDP growth in 2017, down from 2.3% in the May Inflation Report.
The BoE’s purchases of corporate bonds may boost investor appetite for higher-yielding instruments, but UK corporates have little need to raise significant new debt. Slightly lower funding costs will be less of a factor for corporate credit profiles than weak growth and sterling depreciation.
The BoE is cognisant of the potential consequences of very low interest rates on the financial sector. The TFS will enable eligible institutions to borrow central bank reserves at close to the Bank Rate. Funding costs will be lowest for banks that maintain or expand net lending.
This reduces the risk that the rate cut further squeezes margins at UK banks as they face additional pressure on revenues from a contraction in investment and slowdown in consumer spending. Nevertheless, while restating his opposition to negative interest rates, BoE Governor Carney emphasised that there was scope to increase all of today’s measures.
Building societies and banks whose business models rely heavily on net interest income and where liquidity buffers are held largely as cash at the BoE are most exposed to lower-for-longer rates. Their net interest margins are generally highly correlated to base rates, and given their low-risk, low-yield model, lower spreads could affect profitability.
The effect on insurers will depend on whether longer-dated bond yields continue falling. UK non-life insurers may feel the most direct impact because they tend to invest in shorter-duration bonds, and their asset portfolios are reinvested relatively quickly into prevailing yields. This would lower investment income, putting pressure on earnings and potentially driving higher premiums, but insurers would balance this against potential loss of market share.
UK life insurers’ balance sheets are less exposed to interest rates or bond yields, because the duration of their assets and liabilities are closely matched. Lower rates and yields could further reduce demand for annuities, but could modestly help demand for unit-linked or with-profits products given the low rates on bank savings.
