The Bank of England’s reaction towards the vote for Brexit

The “unreliable boyfriend”: That´s the nickname that the City of London has given Mark Carney, the Canadian who has been running the Bank of England since 2013. How did he earn that honour? Several times last year – with the EU-referendum still months and months away, the British economy presented itself in rude health – Carney hinted towards a potential rate rise, only to disappoint investors and analysts by leaving rates at the level they have been since 2009, 0.5 percent. Since then, the City never really trusted the comments that came out of Threadneedle Street.

About six weeks after the historic vote for Brexit, things have changed quite dramatically. As he proved on Thursday, Mark Carney no longer deserves his nickname. Contrary to the past, the head of the BoE met the expectations of the financial community: On Wednesday, the Monetary Policy Committee (MPC), the core decision-making organ of the Central Bank, decided to cut rates to 0.25 percent and to restart Quantitative Easing (QE). In addition to that, the MPC decided to create a new credit facility for banks and house-building societies.

With these measures in place, Governor Carney and the Chancellor of the Exchequer,  Philip Hammond, hope to moderate the negative impact of the EU-referendum on the British economy. Important indicators such as the most recent Purchasing Managers Index (PMI) point towards a drastic slowdown since the end of June. Because of this situation, the BoE has adjusted its forecast for next year: Instead of 2.3 percent as previously forecasted, the central bank only expects meagre growth of around 0.8 percent, the biggest amendment since 1983. After the expected rate cut, it remains to be seen whether the Central Bank will be able to prevent a hard landing. Ultimately, the core problem of the British economy is caused by the uncertainty about the future relationship between the UK and the EU – a problem that monetary policy cannot solve.

According to the report published on Thursday, the BoE expects an increase in inflation, more unemployment and less consumer demand after the vote for Brexit. At 4.9 percent, unemployment is currently at a historic low. However, it is supposed to rise again, to 5.4 percent in 2017 and 5.6 percent in 2018. Because of the expected slump in consumer demand, the MPC has decided to restart QE, a policy measure that hasn´t been used since 2013. Now, the BoE is allowed to buy British government bonds (gilts) of up to 60 billion pounds and, in addition to this, corporate bonds of up to 10 billion pounds. By including corporate bonds, the BoE follows the example of the European Central Bank (ECB) which started buying corporate bonds in early June as part of its QE-program.

The cut in interest rates will most likely reduce the profitability of British banks. Simon-Kucher & Partners, a strategy consultancy, expects operating profits of the 21 largest banks and house-building societies to decline by up to 1.4 billion pounds, now that rates have been reduced to their lowest level for 322 years. In order to prevent a new banking crisis, the MPC introduced a credit program for banks and house-building societies, the so called “Term Funding Scheme” which provides financial institutions with the opportunity to borrow money at rates close to the bank rate. Previous QE-programs included, the balance sheet of the BoE could swell to levels of up to 545 billion pounds thanks to the measures announced on Thursday.

Initially, analysts and markets reacted positively. However, it remains to be seen whether the measures of the BoE deliver the desired results. The underlying problem of the British economy is not access to capital and a lack of funding, but the heightened levels of uncertainty since the British voted for Brexit on the 23rd of June. As long as there is no clarity over the future relationship between the UK and the EU, monetary policy can only do so much to support confidence and investment.

It depends on the outcome of the negotiations between London and Brussels whether the British economy enters a long and severe crisis or whether it recovers relatively quickly and, maybe even more important, only with minor bruises. According to what Theresa May has said, it will take a while until the official start of the negotiations. The Prime Minister intends to wait until early 2017 before she triggers Article 50 of the Lisbon Treaty which will commence the divorce process between the UK and the EU.

Mark Carney is aware of this, as his letter to Chancellor Hammond indicates. “Many of the adjustments needed to move to that new equilibrium (the new relationship between the UK and the EU) are real in nature, and are not the gift of monetary policy makers. Nonetheless, monetary policy can still play a role in smoothing part of this adjustment by appropriately balancing the forces acting to push inflation above the target with those expected to push activity below the economy’s new path for potential output.” Analysts as well as business associations, such as the British Chambers of Commerce (BCC), remain sceptical as to whether the BoE’s actions will produce the desired results. “Lower interest rates may give a helpful boost to market confidence, but have little-long term effect on businesses when rates are already so low”, comments Adam Marshall, acting Director General of the BCC.

Independent of this, Chancellor Hammond seems to be confident regarding the future prospects for the British economy. “The UK economy is fundamentally strong – employment is at a record high, there are almost a million new businesses since 2010 and the budget deficit has been reduced by almost two-thirds as a share of GDP. This is a new chapter for Britain, but we are well-placed to deal with the volatility caused by the vote to leave the EU”, Hammond writes in a letter to the Governor of the Central Bank.

He continues by stating: “I am prepared to take any necessary steps to support the economy and promote confidence. The UK starts from a position of economic strength as we address the challenges and take advantage of the opportunities that will arise as we forge a new relationship with the EU.” Regardless of the slowdown that indicators such as the most recent version of the PMI point out, the BoE has left its growth forecast for 2016 unchanged. In the year of the EU-referendum, the British economy is supposed to grow by 2 percent, the BoE thinks.

After their decision on Wednesday, the members of the MPC will only reconvene in early November. By then, the impact of the vote for Brexit on the state of the economy should be more obvious than it is today. Should there be a further deterioration of sentiment, the MPC might reduce rates further, but not to zero. According to the statement put out by the BoE, the bank rate is supposed to remain a little above zero, potentially avoiding some of the problems that the European counterpart of the BoE, the ECB, finds itself in after the introduction of negative interest rates.

Not only the BoE, but also the Chancellor could be taking further measures soon. He will deliver his first Autumn Statement in November and is expected to announce fiscal stimulus for the ailing economy.

But will Hammond be able to take away some of the uncertainty British firms suffer from? We’ll see.

 

 

 

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How to prevent chaos after a Brexit-vote

It’s the last day of campaigning before the big vote on Thursday. Traders, bankers and money managers are already pretty nervous, judging by what they have done during the past days. Whereas last week saw a strong sell-off of all sorts of assets, particularly those with a strong UK-exposure, investors bought back heavily on Monday and Tuesday. Still, billions have been taken out of UK based funds in the run-up to the referendum. Last week, the FTSE 100 shed close to 100 billion pounds within four days. Banks, particularly Barclays, are deemed to be among those most affected by a vote for Brexit.

The losses have flavoured the debate, now that the vote is imminent. For some, they are an indicator for what might await them on Friday. Although most polls no longer see Leave in the lead – and the bookies just readjusted their odds towards a vote for Remain – many decision-makers working in the financial industry fear that the early morning hours on Friday might provide them with a surprise outcome.

Should there be a vote to leave, experts forecast a sharp decline in Pound Sterling between 10 and 20 percent, a move that could also drag down the Euro. British shares as well as European shares are supposed to tank, with a mark-down in the region of around 20 percent.

With the help of extra liquidity operations, the Bank of England has already provided banks with extra cash in case. Governor Mark Carney is said to be prepared to reduce base rates further, from the longterm historic low of 0.50 percent. In addition to this, the Bank of England could increase the amount of money it spends on asset purchases (currently at 375 billion pounds) and coordinate with other central banks such as the ECB in order to limit any impact on the overall financial system. As recently as Tuesday, the Executive Board of the ECB met in order to discuss potential scenarios after the referendum on Thursday.

Thanks to a number of swap lines between for example the Bank of England and the ECB, officials seem to be confident they are well-equipped for any sort of shock. That’s also what I took away from my recent interview with Andrea Enria, the chairperson of the European Banking Authority (EBA). According to him, national and supranational regulators have made sure that British and European banks are prepared for the worst.

Banks and funds have also taken measures. Depending on whether they are hugely exposed to the potential outcome of the referendum or not, they have hedged some of their positions, sold off risky assets and set up contingency plans should there be a vote to leave.

However, there are people who say that this might not be enough. On Monday, George Soros, the famous investor who successfully bet against the Pound Sterling in 1992, warned of a potential “Black Friday” should there be a vote for Brexit. Unlike in 1992, when the UK dropped out of the Exchange Rate Mechanism, there is not much scope for a cut in interest rates, Soros argued. Assuming that the Bank of England would not embark on a similar mission like the ECB to enter negative interest rate territory, there is obviously not too much room between 0.50 percent and zero.

This is also where it’s no longer just shares and currencies that are suffering. After a Brexit vote, a decline in Pound Sterling would impact ordinary citizens relatively quickly. “Too many believe that a vote to leave will have no effect on their personal financial positions. This is wishful thinking. If Britain leaves the EU it will have at least one very clear and immediate effect that will touch every household: the value of the pound would decline ­precipitously. A vote to leave the EU would also have an immediate and dramatic impact on financial markets, investment, prices and jobs,” Soros said, according to the Guardian.

So will it be all shock and horror on Friday? The first results are supposed to come in around 3 AM in the morning. That might be the time when the turmoil starts, first with money markets in Asia. Thanks to my editors, I will be watching this very closely: On Friday, I will be shadowing a trader at an investment firm here in London, from around 4 or 4:30 AM onwards, and see how he reacts to the outcome of the referendum.

I guess I will be more nervous than him.