Overview: Following the minutes from The Bank of England (BoE) this week we no longer expect the BoE to cut all the way to zero, but instead to stop at 0.5% in March. However, we now expect it to embark on quantitative easing in the near future.
Details: There were two particularly interesting points in the minutes from the latest Bank of England meeting out this week. First, the BoE made it clear that it saw it as necessary to embark on quantitative easing in order to get inflation back toward the target in the medium term: It seemed unlikely that the inflation target could be met solely by cutting Bank Rate. The BoE prefers increasing money through buying credit assets rather than government bonds, as this will help the economy more directly: In the present environment, where particular credit markets were not functioning normally, it was appropriate to consider increasing the supply of central bank money by more unconventional types of asset purchases. Buying private sector assets in such markets... would encourage the flow of credit to companies...The Committee unanimously agreed that the Governor should write on its behalf to the Chancellor to seek authority to conduct purchases of government and other securities, financed by the creation of central bank money.... We believe this letter could be published any day and that quantitative easing will be embarked upon in the very near future.
The second important takeaway from the meeting was that the BoE is no longer likely to cut rates all the way down to zero. The members had a lengthy discussion of the disadvantages of zero rates, which might hurt banks profitability and hence obstruct more lending. Since banks deposit rates are normally below the Bank Rate a zero rate would be a disadvantage as deposit rates could not be lowered below zero. Instead, banks could not lower lending rates as much, but in some cases banks were contractually obliged to do so and this would hurt their profitability. So where is the lower bound? Actually it was mentioned that one member (Blanchflower) wanted to go to the lower bound as a result of the February meeting. Since he voted for a cut of 100bp that would imply that they see the lower bound as 0.5%.
Outlook and market view: We therefore no longer expect the BoE to cut all the way down to zero but instead cut to 0.5% in March and stop there. Sterling has been trading more or less sideways against the euro this week at around 0.89. We believe that the quantitative easing will give a push toward weaker sterling and hence see a move to 0.93, on a three-month horizon. Bond yields are in a bottoming process and caught between outlook for quantitative easing, on the one hand, and heavy bond issuance on the other. We believe 10-year yields could fall further toward 3% - the low reached earlier this year.
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