The fall in gilt yields into negative territory on Monday implies that investors think that the Bank of England will cut interest rates to emergency levels and keep them there for the foreseeable future. We expect a 25bps cut to 0.50% soon. But as the hit to the economy from the coronavirus is likely to be temporary and fiscal policy is becoming more supportive, we suspect that the markets have gone too far.
- The fall in gilt yields into negative territory on Monday implies that investors think that the Bank of England will cut interest rates to emergency levels and keep them there for the foreseeable future. We expect a 25bps cut to 0.50% soon. But as the hit to the economy from the coronavirus is likely to be temporary and fiscal policy is becoming more supportive, we suspect that the markets have gone too far.
- Alongside the fall in equity and oil prices on Monday gilts rallied, causing the yield on some short-dated gilts to fall into negative territory for the first time. The 2-year yield fell from 0.56% at start of the year to an intra-day low of -0.04%, the 10-year yield fell from 0.79% to just 0.07%, and the 30-year yield fell from 1.28% to 0.38%. (See Chart 1.) Yields reversed some of their fall on Tuesday morning; the 2-year yield is at 0.19% and the 10-year at 0.31%. But they remain extremely low by historical standards.
- The fall is largely due to a reassessment of the outlook for interest rates. Together with the expected hit to the economy from the coronavirus, the deflationary shock of the collapse in oil prices has caused investors to fully price in a cut in the policy rate to 0.25% by June. The 0.31% yield on the 10-year benchmark reflects that investors now expect policy rate to stay close to that level for the next decade!
- We have highlighted that the Bank of England will cut interest rates at or before its 26th March meeting by 25bps, or possibly 50bps, accompanied by targeted measures designed to help firms weather the next few months. (See here.) That’s based on the idea that the virus is a temporary hit to the economy, and GDP stagnates in Q2 but recovers thereafter.
- Of course, the eventual scale of the pandemic and in turn the economic impact is highly uncertain. If the outbreak in the UK is particularly severe or long lasting it could tip the economy into recession. In response, the Bank of England could cut interest rates further and restart asset purchases. But as incoming Governor Andrew Bailey doesn’t “regard negative official rates as a plausible tool” for fear it would make small banks and building societies unviable, 0.1% will probably be the lowest the Bank would be willing to go.
- Investors’ biggest fear is that this stimulus proves insufficient to get the economy back on track. The fall in long-dated gilt yields to record lows suggests that investors have lost faith in the effectiveness of monetary policy in raising inflation after a downturn. If that’s true, the UK could end up with low growth and low inflation for a long time with interest rates stuck close to zero. That’s a risk worth considering, but in our view it’s not the most likely scenario. So long as the economic fallout from the virus is temporary the Bank of England won’t have to keep rates at emergency levels forever, especially as the UK government has ample fiscal space and political will to use fiscal policy to stimulate the economy. That’s why we think interest rates will be higher than investors expect over the next few years. (See Chart 2.)
- It is difficult to make a call on the path of future interest rates while uncertainty about the spread and economic implications of the virus is so high. But our hunch is that the market is pricing in a worst case scenario that is unlikely to materialise. The upshot is that we don’t think negative gilt yields will become common in the UK.
Chart 1: Gilt Yields (%)
Chart 2: Expected Interest Rates (%)
Sources: Bloomberg, Capital Economics
Andrew Wishart, UK Economist, +44 20 7808 4062, email@example.com