Is the UK moving closer to NIRP?

The discussion around whether UK interest rates might move negative in the aftermath of the COVID-19 policy response has ebbed and flowed all summer.

From Andrew Bailey’s comment of “ruling nothing out,” in response to the question about a negative interest rate policy, the market seemed to have concluded that it was, in fact, unlikely to happen and that the effective lower bound¹ (ELB) for UK rates would remain at 0.1%.

Since then, Monetary Policy Committee member Silvana Tenreyo made a comment in an interview that the Bank of England had been viewing how “successful” negative rates had been in other countries and hence they were evaluating further.

While many countries have moved into negative interest rate territory (Japan, Switzerland, Denmark, Sweden), we look to our closest neighbour — the Eurozone — to assess success. The European Central Bank (ECB) took its rates negative back in 2014 and reported that this successfully lifted the supply of credit. Over time, the ECB noted that negative rates were having a material impact on banks’ margins, leading them to curtail lending instead of lending more. The ECB has since refined the policy and now tiers the application of the negative rate; only applying it to a portion of banks’ deposits (the tiering is based on a multiple of the minimum amount of reserves banks are required to hold with the ECB).

Last week, all UK lenders were contacted with a questionnaire to check how prepared they were for a central bank move to cut interest rates below 0%. The focus of the questions is not about how this might impact lending or the bank’s profitability, but only on the plumbing of their IT infrastructure and whether it could cope. The banks have until 12 November to respond to the request.

From the interest rate market’s perspective, using the forward curve as the indicator, we already see UK rates (out five quarters) dipping into negative territory.

Over the past few months, Chatham has produced some insights to explain NIRP (negative interest rate policy), and ways to manage this as a borrower. In particular, the risk (or existence) of negative rates has increased lenders’ propensity to incorporate interest rate floors into their lending documents. These floors are usually set at 0% but have been inching up recently as lenders look to boost their returns by setting this floor at 0.25% or sometimes higher. Borrowers should see this as another “fee” within the loan structure and calculate the cost of it in different interest-rate scenarios to make sure they understand the repercussions.

More critically is how the existence of these floors in a negative-rate scenario interacts with a hedging product. We see borrowers focus on the loan document and not take into account the impact on their hedging.

In summary, the probability of a move to negative interest rates seems to have increased in the past few months. The final decision now seems to ride on whether the banks will respond with confirmation that their IT is ready to incorporate negative rates. Then we need to get our minds around the fact that fundamental finance theory is completely turned on its head.

¹ ELB is the level to which rates can usefully fall. Anything lower than the ELB either has no impact or is counterproductive.