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Bank of England’s attempt to stimulate UK economy

As the aftershocks of Brexit ripple through the UK the world has waited for the Bank of England’s response. Many have doubted the effectiveness of monetary policy to off-set the economic impact caused by the vote to leave. There are years of uncertainty ahead and uncertainty is the thing most hated by investors.

Some have gone as far to say that comments from the Governor of the Bank of England have talked the UK into a recession. The banks fear that near zero interest rates will make it difficult, if not impossible, for them to make a profit. And many investors believe that years of accommodative monetary policy have reduced its ability to revive an economy.

This was the backdrop to last week’s announcement. On 4 August 2016 a comprehensive package was released with the aim of stimulating growth in the UK economy. This included the expected cut in interest rates but also some more surprising announcements:

  • A new funding facility called the “Term Funding Scheme” to make sure that rate cuts trickle down from the banks to borrowers.
  • A £60billion bond purchase programme was also announced.
  • As well as £10billion in sterling corporate bond purchases.

Term Funding Scheme

The Term Funding Scheme was introduced to complement the rate cut. The Bank of England will lend up to £100bn to UK banks at a lower bank rate for a period of four years. As the UK bank’s net lending increases, they will have greater access to cheaper funding provided by the Bank of England. This scheme is designed to reinforce the transmission of the base rate cut to households and businesses. This scheme should in theory offer some defence for bank margins rather than a direct boost in lending from the scheme.

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This method of enhancing the rate cut transmission is not something new, the European Central Bank set the precedent in their March policy meeting where the central bank agreed to lend to European banks at -0.40%.

Corporate Bond Purchase and quantitative easing

Arguably the X factor in this stimulus package is the £10billion on buying up investment grade debt issued in sterling by top companies in the secondary market, on top of a further £60 billion for UK Gilts. The universe of companies is more than 100 non-financial firms which are deemed to make a ‘material contribution’ to the UK economy.

The move effectively put the central bank amongst ordinary investors and institutions as market participants. This will boost demand for this asset class and push up corporate bond prices. This £10bn corporate bond purchase is designed to encourage large UK businesses to continue with their borrowings and investments, therefore helping to drive the UK economy forward.

This will likely to put further downward pressure on the yield of this asset class, similar to what we have seen in the Euro denominated corporate bond space following a similar policy introduced by the ECB. This would encourage investors to move to potentially more risky asset classes such as GBP high yield bonds or equities to generate higher returns. Whist this policy can be regarded as a more aggressive measure to tackle economic concerns, Mark Carney’s sceptics may argue that the size of both corporate bond purchases and additional quantitative easing in the latest package is still fairly moderate. But as the governor promised in the press release following the MPC meeting last week, they still have plenty of firepower left in the tank.

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