For the first time in it’s 324 year history, the Bank of England is exploring the possibility of negative interest rates in an attempt to stimulate the economy. Andrew Bailey, the BoE governor, confirmed negative rates were under “active review” when questioned by MP’s, in the same week bond investors accepted that they would need to pay to lend money to the UK government.
If this unprecedented change to interest rate policy comes into effect what impact would that have on sterling and the foreign exchange markets?
Let’s start from the top…
What are negative interest rates?
A negative interest rate policy is when a central bank, like the BoE sets its target nominal interest rate at less than zero per cent. Countries, including Japan and Sweden, have already established a negative interest rate policy but the UK is yet to do so.
What do they achieve?
Negative interest rates aim to encourage borrowing, spending, and investment in order to stimulate a county’s economy. Negative deposit rates discourage saving as money that sits in the bank incurs charges. In times of uncertainty, such as the present COVID-19 crisis, people and businesses tend to become risk-averse and hold onto their capital/cash rather than spending and investing it. Therefore, negative interest rates counteract this frugality by encouraging people to borrow and spend thereby giving the economy a much-needed cash injection.
The Relationship between negative interest rates and currency?
Typically, when central banks cut interest rates, the exchange rate tends to fall as well. In 2008, for example, when the BoE cut its base rate from 5 % 0.5%, Sterling fell by as much as 25 % against all major currencies. Similarly, after the ECB introduced negative rates on bank reserves, the exchange rate of the euro versus the U.S. dollar fell continually over the next few months.
Will the UK pursue a negative interest rate policy?
The announcement that negative rates are under review indicates that they could well become a reality this summer. As the UK heads towards the deepest recession on record the government and the central bank will be looking to use all avenues to jump-start the economy. Indeed, government bond yields went negative last Wednesday, a reality that has presaged other central banks to send interest rates sub-zero.
However, the UKs large trade deficit and huge import industry will be adversely affected by the negative impact on the value of sterling resulting from a further rate cut. The B of E is faced with a tricky balancing act, caught between the desire to encourage investment and spending without damaging industries that rely on a strong pound.
If negative interest rates were introduced by the BoE, one would expect to see Sterling value nose-dive, especially in the short term. It is likely, however, that Andrew Bailey will want to keep such a policy as a last resort. With Brexit related troubles brewing once again negative rates will be on the agenda for some time and Sterling will be vulnerable to any suggestion of a negative rate reality.
Speak to Privalgo in order to ensure that you are mitigating your risk and prepared for any scenario that the current volatile economic climate may bring.