Full BOE Preview, And A Look At What UK Corporate Bond QE Will Look Like

After several prominent central bank disappointments over the past few weeks, culminating with last week’s BOJ fiasco, earlier this week the RBA finally did as it was expected by both the market and a majority of analysts, when it cut rates by 25 bps to a record 1.50%, even if the reaction was unexpected, sending the AUD sliding briefly then soaring as the accompanying statement suggesting far less dovishness would follow.

Which brings us to tomorrow’s Bank of England decision, where as of this moment the OIS market shows that a 25bps rate cut is 100%  priced in. But a plain vanilla rate cut may be just the tip of the Iceberg: as the WSJ writes, piggybacking on an analysis by BofA’s Barnaby Martin, investor bets are rising that Mark Carney could “start snapping up” corporate bonds as part of the stimulus plan to be announced tomorrow. 

As a reminder, the BoE previously bought corporate bonds between 2009 and 2012. As BofA writes, the purchase numbers were not headline-grabbing (£2.1bn) but the aim of the programme back them was a lot different to what we could envisage now. Using the ECB’s template to create a £ CSPP equivalent, the BoE would end up with an eligible universe of £128bn (44% of the Sterling credit market), and could possibly grow it to £211bn if they bought Euro-denominated bonds (as suggested in ‘09). With a universe this big, the BoE should be able to sustain around £2bn of corporate purchases a month.

But before we look in depth into the possibiliy of a British CSPP, here is a detailed breakdown of what to expect, and what Wall Street believes will happen, courtesy of RanSquawk:

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• Bank of England are widely expected to cut rates to 0.25% with a 25bps rate reduction fully priced in OIS markets.
• The central bank is also touted to announce further stimulus measures including the potential restart of its QE program (APF currently stands at GBP 375BN) and the Funding for Lending Scheme.
• 2017 GDP growth forecast is likely to see a significant downgrade amid early signs of a deterioration in the UK economy, while GBP depreciation is likely to support 2017 Inflation forecasts.

BACKGROUND

The Bank of England will reconvene for the second time since the UK’s decision to leave the EU, whereby they are widely expected to ease monetary policy. This view is supported by the fact that at the last meeting the MPC said that most officials saw the need to adjust policy in August. Furthermore, Governor Carney himself has already announced that the central bank will probably need to take action in the summer, which leaves Thursday as the remaining option.

POST-BREXT DATA/COMMENTARY

Heading into the meeting the BoE has had little (Brexit exposed) economic data to act on. Most notably the PMI figures for July, in which Mfg. and Composite readings contracted to 41-month and 87-month lows, respectively, while the key Services figure saw its largest decline in 7-yrs. Given that services accounts for 79% of the UK economy, a severe contraction in this sector has obvious consequences for GDP and jobs moving forward. Allied with this, tier-2 data points (which would not normally garner significant attention) have also showed sharp declines in business confidence and as such contributed to the heightened uncertainty regarding the UK economy, reinforcing the case that policy adjustments are needed.

Against that backdrop, several MPC members have recently stated that they are willing to ease policy, with BoE’s Haldane stating that this meeting will likely see material easing while there has also been a shift in some of the more hawkish members. In particular BoE’s Weale, who in a sudden U-turn from his usual stance shifted his view in favour of easing.

POSSIBLE MEASURES

In terms of touted measures, OIS markets have fully priced in a 25bp rate cut while there is also a small chance priced in for a 50bps rate reduction. However, a cut in interest rates will likely weigh on GBP which would be somewhat of an undesirable effect at present, given that the currency is already hovering at more than 30-yr lows, while it would also lead to damaging import price inflation. Additionally, with Governor Carney previously stating that he does not believe that rates “too low” (or negative) could have positive outcomes, this would suggest that there is little room to manoeuvre.

At the last meeting, the central bank’s minutes stated that the MPC had an initial exchange of views on the various possible packages of measures. Consequently, this alludes to the fact that the BoE is looking for further measures other than cutting rates. In turn, this has raised the possibility that the bank could re-launch the Funding for Lending Scheme which would ensure ample liquidity by allowing commercial banks to borrow funds cheaply in order for this to be passed on in the form of cheap loans to firms. Analysts at Nordea Bank note that the central bank could enhance the FLS either by broadening its scope to include household lending or by improving the terms of liquidity provision.

Moreover, some participants expect the BoE to implement a new QE programme (Asset Purchase Facility which currently stands at GBP 375bn) with analysts noting that Gilts are likely to account for the majority of the new asset purchases with also the inclusion of corporate bonds. Previous expansions to the QE programme have seen holdings rise in GBP 50-75b1n increments.

INFLATION AND GROWTH FORECASTS

The MPC will also arm themselves with the latest set of inflation forecasts, which they have stated that will act as an important guide as to the magnitude and calibration of stimulus measures. Additionally, the July meeting minutes stated that the depreciation in GBP (Trade Weight fallen around 12%) has put upward pressure on inflation with BoE’s Haldane commenting that inflation could overshoot its 2% target, in turn inflation forecasts may be upgraded with some suggesting 2017 inflation may be over 2% (Prey. 1.5%). On the other hand, with economic indicators showing early signs that the UK economy is weakening significantly, GDP outlook is likely to see sharp downward revisions. Prior to the Brexit vote, the BoE forecast GDP growth for 2017 at 2.3%, with the consensus amongst analysts now at 0.6% (Prey. 2.1%) while some are expecting growth to be slashed to 0.0%.

MARKET REACTION

In terms of market reaction, given that OIS markets have fully priced in 25bps rate cut, this alone may be met with disappointment and as such see some initial upside in GBP. A similar reaction may be seen in GBP if the vote split is deemed too tight (5-4) with also a flattening of the UK curve. While a unanimous 9-0 in favour of a cut might suggest that a follow up move is on the table leading to potential pressure in GBP. Additionally, if a plethora of measures are utilised by the central bank involving a potential restart to its QE programme allied with a rate reduction and credit easing, may lead to upside in equities. While Gilt yields could also post fresh record lows as many analysts note that a restart to QE will likely include the purchase of Gilts.

SELECTED ANALYST EXPECTATIONS

• BofAML expects the BoE to cut interest rates by 25bps, alongside a GBP 50bIn expansion in the APF and credit easing package.
• Goldman Sachs forecasts an increase in asset purchases of over GBP 100bIn over the next 6 months, with a mix of sovereign and corporate bonds.
• HSBC states that the central bank will cut rates by 25bps, coupled with an announcement of measures to support credit to the real economy.
• Nordea Bank sees a 25bps cut to 0.25% with a GBP 100bIn increase in the APF over the next few months.

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Which brings us back to the all too real possibility that the BOE will, in a few hours, unveil its own CSPP program, copying what the ECB did back in March.

Here is BofA’s Barnaby Martin, laying out “the case for a £ CSPP”

Despite the benign backdrop for yields and spreads, we do feel that there is a strong case to be made for the Bank of England pursuing another corporate QE programme for the Sterling credit market. To be clear, market dysfunction in not the problem. Yes, uncertainty is high after the Referendum outcome, but the Sterling credit market is clearly not shut given the three recent new issues over the last week (BAT, Brown-Forman and Santander UK).

But in a post-Brexit world, if the UK is to flourish on its own then it must have a vibrant and deep credit market underlying it, especially if the ability of the UK banking sector to lend becomes challenged amid a backdrop of lower interest rates and rising delinquencies. Building a “super competitive-economy” with low corporation tax and investment from China, for instance, requires a £ credit market where the ability to issue bonds and raise capital is not in doubt.

But the reality is that the Sterling credit market – in its current form – is far from this. In our view, it looks to have been suffering a “slow death” of sorts over the last few years. Chart 7 shows that issuance of £ corporate bonds has been dwindling since 2013. This year, there has been only £4bn of non-financial IG issuance in the Sterling credit market, and by year-end it is unlikely to get anywhere near the lofty levels of issuance seen in 2012 (£33bn).

But we don’t think the dwindling in £ issuance reflects the risk-averseness of UK companies. On the contrary. We believe the explanation is simply that the ECB’s extraordinary monetary policies of the last few years have pulled UK (and global) funding capital into the Euro credit market. Chart 8 makes this point. In 2009, 53% of UK corporates’ liabilities were denominated in Sterling. Today, the figure is just 29%.

The allure of negative yields in Euros and the market-pacifying impact of the ECB’s CSPP have driven UK companies to fund more and more in Euros (and prior to this the $ credit market, helped by the attractive basis swap).

But the selling point for greater investment in a post-Brexit UK economy cannot be the ability of UK companies to issue in Euros! (especially with rising currency volatility). Thus, we think the BoE would be playing its part in supporting the UK economy if it helped revitalize the £ credit market with a new corporate bond purchase programme.

In effect, we believe there is a need to “balkanize” credit markets again, especially the Sterling corporate bond market. We think a “£ CSPP” would act as a nice counterbalance to the ECB’s CSPP, and would return European credit markets to a more level playing field. And importantly, we think there would be the possibility of Carney and Draghi “coordinating” their respective corporate bond buying.

What could a £ CSPP look like today?

To bring the £ credit market “back to life”, we think a BOE corporate QE programme would need to be much bigger than 2009’s version. Only regular and continuous buying would ensure that depth returns to the £ primary market. Just as Mario Draghi is showing with his corporate bond buying programme, tightening spreads helps achieve this (as well as purchasing corporate bonds in the primary market,  which the BoE has never done before).

In Chart 12, we draw from the methodology of the ECB’s Corporate Sector Purchase Programme to create the same idea for the Sterling credit market (we call it the £CSPP). We calculate the volume of eligible corporate bonds that would be available for the Bank of England.

• We start with our UR00 Sterling corporate bond index (which includes financials and non-financials). We then exclude bank debt, but keep insurance (in line with ECB CSPP methodology),
• We then exclude all subordinated debt (again in line with ECB CSPP methodology),
• We then limit the universe to “UK relevant companies” which means either a) UK domiciled companies or b) non-UK domiciled companies with significant exposure to the UK (which we define as companies having at least £3bn of Sterling corporate bonds outstanding). This results in £128bn of eligible corporate bonds for the BoE.
• As an additional filter, we note that in 2009 the BoE stated that they were prepared to buy corporate bonds denominated in currencies other than £. In the end they kept purchases just to £. But here we add the Euro-denominated bonds issued by UK corporates to which the rules above apply. In this case, we get £211bn of eligible corporate bonds for the BoE.

How big are these numbers?

• £128bn is 44% of the Sterling IG corporate bond market.
• Interestingly, we think the ECB has an eligible universe of €710bn for their CSPP while the Euro IG corporate bond market is €1.72tr in size (41%).

The ECB is currently buying between €9-10bn of corporate bonds per month. If the BoE was to create their own £CSPP then we think around £2bn of purchases per month would be a sensible starting point.