Negative interest rates: the impact on UK fund management

The course of political and economic events in the UK has been punctuated in recent years by a series of unlikely events. At some point during the next 12 months we may see another once unthinkable change: the Bank of England’s base rate moving below zero.

On the 12 October the Bank of England sent out an information request to bank CEOs to provide an indication of their readiness with regard to sterling interest rates falling to zero and beyond into negative territory. This follows comments over the summer from the BoE’s governor Andrew Bailey, highlighting negative rates being in its “toolbox” of possible monetary policy measures. He stressed that the BoE had no plans to use negative rates at that time; and observed that the experience of other central banks using them suggests negative rates are most effective at boosting consumption and growth when used during an economic upswing.

Some commentators suggested that Bailey’s words were intended to signal to the financial markets that the BoE was ruling out using negative rates for the foreseeable future. The October letter distinguishes between negative and zero rates, focusing on operational challenges and points out this engagement with industry is not indicative that the Monetary Policy Committee will employ a zero or negative policy rate. But at the time of writing (October 2020) the markets are pricing in the possible introduction of negative rates at some point during the second half of 2021. The markets are not always right, of course, but what impact would negative rates have on the banking and investment industries?
 

No-deal Brexit could spark negative rates

“My personal opinion is that base rates will not go negative,” says Dave Ramasawmy, director at RBS International Markets. “The Bank of England had a chance to do that earlier this year, following the coronavirus emergency measures, and it didn’t do it.”

But he and many of his colleagues do think the chances of negative rates being used will increase if the UK fails to agree a Brexit trade deal with the EU; while the economy continues to struggle to recover from the coronavirus pandemic.

“If we see the shock of a no-deal Brexit I think we will see more use of quantitative easing and negative rates – and maybe not just one cut,” says Matthew James, head of markets at RBS International. “With Covid-19, we’re seeing increased rates of infection – what will that mean for confidence to invest?” He also thinks the outcome and aftermath of the US presidential election in November could have a meaningful effect on financial markets across the globe, thereby adding to the economic uncertainty.
 

“The use of negative rates in Europe means that many corporates now have experience of borrowing facilities and managing cash in a negative-rate environment”

Matthew James, head of markets, RBS International
 

The rationale behind negative rates is to encourage banks to lend more freely to businesses and other customers, and for consumers and businesses to spend more freely, rather than hoarding cash. But in practice, where negative rates have been used in recent years, including in the eurozone and Japan, the policy has not always had the desired effect.

Negative rates would create problems for banks, squeezing their margins and profits if they were reluctant to pass negative rates on to customers; and forcing them to amend some financial contracts and adapt IT systems and business processes. Strategies on deposits, lending and interest rate hedging would all need to change. Economists continue to argue over how negative rates affect those strategies, particularly during a period of economic stress and uncertainty.
 

A new frontier in customer relationships

James suggests that banks’ strategies would evolve as it became clear how negative rates were to be used. “If the move to negative rates is seen as something that will be needed for a while to kick the economy into life, the Bank of England will want people to be charged for keeping deposits,” he says. “You might see things like banks charging people over a certain limit and passing the cost on to larger corporates/institutional customers..

“We’ve got experience of that in Europe, so this isn’t new to the financial industry – but for the UK it’s a new concept,” he continues. “It will be difficult for some customers. It will be a defining point for banks in the way they interact with their customers.”

“If you’re thinking about this from a bank’s perspective, without losing sight of the need to support customers, this means the bank will need to be very specific about the treatment of deposits,” says Matthew Richardson, treasurer, RBS International. “Not all deposits are created equal. Banks will pay for high-quality liquidity.”

Many banks have also set a limit of 0% in borrowing contracts, so would not actually have to pay borrowers to borrow. But the way lenders and borrowers weigh up decisions would change.

Corporates and fund managers would probably be better able to adapt than most other bank customers. “The use of negative rates in Europe means that many corporates now have experience of borrowing facilities and managing cash in a negative-rate environment,” says James. “Over the years we’ve spoken to customers about this and put hedging solutions alongside it that allow them protection, should interest rates go negative.”

Some fund managers may also consider using foreign exchange to chase yield, exploiting opportunities related to the interest rate differential between currencies. This strategy may introduce other risks, particularly if the currency is non-functional for that fund.

Negative rates would also have noticeable effects on the bond market, where UK gilt yields are already negative. “An investor might see a safe government bond as a more attractive option than putting cash on deposit if rates go negative,” says Ramasawmy, “or more attractive than a higher yield on a riskier asset.”

James points out that bond issuers with issuance prices benchmarked to government bond yields would also be able to borrow from the financial markets at a more attractive rate, which may help them to exploit other investment opportunities.
 

Assessing the long-term impact

If it is possible to create effective strategies to managing the consequences of negative rates, should fund managers, bankers or business leaders be worried about their possible introduction?

“The eurozone went into having negative rates a while ago and the markets have got used to that,” says Ramasawmy. “But what does it say about the strength of your economy if you have negative rates for a prolonged period?

“For the UK, against the backdrop of Brexit and Covid-19, I think it could have long-lasting effects. The UK has to pay for the furlough scheme and everything else the government has been doing during the crisis; and for all the infrastructure projects the UK has committed to – at a time when unemployment is expected to rise after the furlough scheme ends.

“So I think having negative rates means we could end up not being able to raise them again for a long time. But until we’re out of this Brexit and Covid-19 recovery phase there’s going to be the potential for negative interest rates.”

In difficult times, the BoE may yet try this remedy for our economic troubles. Investors, fund managers, bankers and their clients should be preparing for that possibility, however strange the idea may still seem.