Bank of England cuts rates and restarts quantitative easing

The past few days have been a baptism of fire for the Bank of England’s new governor, Andrew Bailey. On 19 March 2020 the Bank took new steps to help UK’s economy withstand COVID-19. After dropping the Bank Rate to 0.25% as recently as 11 March, the Bank has gone further, cutting rates to the record low 0.1%. In addition, quantitative easing (QE) has been increased by a further £200bn, bringing the Bank’s holdings to £645bn.

The Bank Rate is now about as low as it can go without reaching zero. Lower interest rates should take some pressure off borrowers, but it remains to be seen how much of the reduction gets passed on to the rest of us. More important might be how quickly. Interest rates tend to affect the economy quite slowly, so we don’t expect this move to have a big impact quickly.

However, lower rates have another function. When rates are lower it becomes relatively less attractive to save money, or perhaps more importantly, less attractive for commercial banks to hold reserves with the Bank of England. This will hopefully increase spending and lending, but it could backfire if people think they need to save more to compensate for the lower interest rates.

Ultimately, we don’t think this is going to help all that much. Rates were already very low and now they are very, very low. Even if the impact is felt in a timely manner, we don’t think it will be all that large.

The Bank also plans to restart QE by buying another £200bn of bonds, mostly government bonds known as gilts. This is in addition to the £445bn of bonds the bank already owns. The goal here is to improve conditions in the gilt market. By buying bonds and providing ready cash the Bank can increase the total amount of cash in the system, hopefully making it run more smoothly.

Additionally, buying up longer dated gilts should support their prices and keep long term interest rates down. The knock-on effect might be to support other asset prices, such as stocks or property. It is worth pointing out that this doesn’t always happen: after the Federal Reserve, the US central bank, restarted its QE programme markets continued to fall. We’re not saying this is about to happen to the FTSE, just that investors shouldn’t rely on the Bank of England to pull us out of this bear market.

We think more QE should help with the gilt market, and that matters because it looks like the government will want to borrow a massive amount of money in the next few months. And the last thing we need is another financial crisis on top of a pandemic.

While it has occurred to us that large government deficits financed by the Bank of England’s printing press could lead to inflation in the future, we’d point out that this didn’t happen after QE was introduced for the first time in 2009.

While central banks get a lot of attention, we’d stress that they can’t actually solve this pandemic problem. Nothing the Bank does will help fix global supply chains, slow the rate of infection or aid sick people in getting back into work. But they can ease financial conditions to give otherwise sound businesses and households a fighting chance at coming through this with minimal hardship.

With this in mind, we think the Bank’s response is correct. They may need to do more in future, but the new governor has shown he’s not afraid to make big moves. That could help restore some confidence to the market, which may be the best thing he can do right now.

What does it all mean for high street banks? – Nicholas Hyett, Equity Analyst

One of the goals of the Bank of England’s most recent round of QE and lower interest rates is to get high street and commercial banks’ lending in the real economy. That means cheaper loans and more of them for businesses and consumers.

However the cut is less good news for the banks themselves.

Banks will, generally, have little choice to pass the interest cut on to borrowers – thanks to a combination of intense competition in areas like the mortgage market and base rate tracking loans. But interest rates on savings accounts are already on the floor, and banks will struggle to cut them more without risking customers taking their savings elsewhere.

That will squeeze banks’ ‘net interest margins’ – the difference between what a bank pays depositors and charges borrowers. It’s bad news for profitability – although banks with more exposure to fee generating investment banking activities will have some protection.

It doesn’t help that economic downturns tend to come with an increase in bad loans – hitting profitability still further. The spectre of rising unemployment as companies look to trim costs and conserve cash adds to the headache for banks that are overly exposed to riskier credit card and car finance loans.

The good news is that banks are far better capitalised than they were even a few years ago. That should make them better able to withstand a sustained period of weakness. Improved liquidity through QE and access to cheap funding will help to offset the net interest margin headwind to some extent and are good news for banks’ long-term health.

However, with profitability likely to fall, the dividends, which have only recently returned to the sector following the financial crisis, could be under pressure.

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