By John McNeill
If asked ‘when do you expect Bank Rate to rise in the UK?’ My answer is ‘Page 64 of the November 2013 Financial Stability Report from the Financial Policy Committee’. This answer has the twin attractions of avoiding a potentially embarrassing hostage to fortune question and also forces one to think that any tightening of policy in the UK. may take a different form than in it has done in the past.
The UK economy has performed admirably well this year after a very sluggish start. Surveys which combine activity readings in the construction, manufacturing and service sectors are at levels which would have been consistent with Bank of England tightening in the past. The most commonly cited reasons for the improvement in activity in the UK is reduced sense of crisis in the eurozone (the UK’s largest trading partner by far) and improved access to and reduced cost of credit, mainly due to the Funding for Lending scheme.
The Bank of England now uses a form of communication termed ‘forward guidance’, which links any change in Bank Rate to a specific level of one economic variable. Economists find this approach economically incoherent, but it has the benefit of simplicity to households and firms who seem to have taken the message that the Bank Rate will not be raised for at least 18 months.
The Bank has stated that it will not consider raising the Bank Rate until the unemployment rate reaches 7% and even then, this will not be a trigger for action but merely a point at which further guidance will be provided.
But back to Page 64. Here you will find Table 5.A.: “Tools to mitigate risks from the housing market”. There is a long list of current and potential future policies to deal with excessive appreciation in house prices, some of which are already used in other countries. My conjecture is that macro and micro prudential policies will be very important in this cycle and are sufficiently powerful to reduce the need for any change in the Bank Rate at all.
Let us consider one of the potential future tools, namely “Recommendations on maximum loan to value ratios, loan to income ratios, debt to income ratios or mortgage term”. Let us assume the terms on loans change from 95% LTV to 60% LTV, from four-times loan to income ratio to 2.5 times and from 30 years term to 20 years.
I would suggest that such a change if implemented would have an immediate and dramatic impact on the ability to borrow and therefore on housing activity. Other policies could be implemented to insist that banks made greater capital provision for certain types of lending. Household and corporate credit availability could be curtailed by these measures. While monetary policy is said to operate with long and variable lags, credit policy will have an immediate and potentially dramatic impact.
My other point relates to human psychology. The Central Bank community has been criticised for allowing a bubble to build in real estate assets in the lead up to the financial crisis in 2007/8. They are further charged with being asleep at the wheel as borrowing and lending spiralled higher. Having suffered such a searing episode, it would seem natural that policy makers will err on the side of caution this time around. There is more chance of snuffing out housing activity and what is seen as excessive lending than of allowing a re-run of a recent painful episode.
For these reasons, it is possible that any policy tightening will take the form of macro and micro prudential policies. Only if these policies fail to slow credit creation and potential overheating will a rise in the Bank Rate be considered (again assuming that the unemployment rate has reached the 7% review level).
For the gilt market, this means that short-dated yields are likely to remain at very low levels for the foreseeable future. Two-year yields have been no higher than 0.69% since October 2011. If economic data continue to improve five-year and 10-year yields will tend to move higher, however, there is a natural limit to how far this move can go if two-year yields don’t move very much.
In fact the current gap between two-year gilt yields and five-year gilt yields of 1.2% would be considered wide relative to the history of this spread. The gap between two-year gilt yields and 10-year gilt yields is around 2.4%. Again this is relatively wide relative to its history and the widest this spread has ever been in recent history is around 3%. Longer-dated gilt yields will be supported by continued life and pension fund demand, as mature pension schemes seek to better match their assets and liabilities.
The total return for gilts for 2013 year-to-date is around -3.45%. This comprises around 3.23% of coupon income but this has been overwhelmed by -6.68% of capital loss. This is the first negative total return on all-stock gilts since 2009. Since 1986 there have not been two successive years of negative returns for all-stock gilts. This is not a prediction for 2014, merely an observation that a further negative total return year would be historically unusual.
John McNeill is a fixed income manager at Kames Capital
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