Monetary easing may include fresh round of asset purchases. Hugo Coelho reports
Tomorrow's news on the Bank of England's (BoE) monetary policy decision is unlikely to be happy reading for UK insurers. The Bank's Monetary Policy Committee will meet for the second time in three weeks to start spelling out its response to the economic fallout of Britain's vote to leave the EU, and analysts are betting the farm that the BoE will ease monetary policy conditions again.
This will undermine the investment returns of hard-pressed insurers and incentivise them to hunt for yield in longer duration or sub-investment grade credit, experts say. However, the size of the problem will depend very much on the policy details.
With the direction of policy in the medium term largely pre-determined, it is the speed and the mix of measures that are expected to dominate the conversation in the Bank's committee of nine. "There are some who want to use a sledgehammer to crack the nut and others who would rather keep calm and carry on [until more data is available]," explains David Page, senior economist at Axa Investment Managers.
A 25-basis point reduction in interest rates to 0.25% has been largely priced-in by the markets. The remaining uncertainty is about whether the bank will restart its programme of asset purchases.
Hetal Mehta, senior European economist at Legal & General Investment Management, puts the probability that the BoE will launch a quantitative easing (QE) programme of £75bn ($100bn) to £125bn at 65%. In a note to clients, Stewart Robertson, senior economist at Aviva Investors, also predicts a fresh round of asset purchases of £75bn over three or six months, but describes the forecast as "speculative".
In contrast, Axa IM's Page argues the BoE is more likely to hold fire until November, when a £50bn to £100bn programme might be launched. In the medium term, he expects asset purchases to reach about £200bn.
Expanding scope to corporate bonds
In addition to the size, the scope of the programme will determine how much pain the Bank's action to prop the economy will inflict on insurers.
One unknown is whether the BoE is going to continue buying gilts, or whether it will follow in the footsteps of the European Central Bank (ECB) and expand into investment grade corporate bonds.
In the past, barring a small programme of corporate bond purchases in 2009, the BoE has concentrated on government bonds. Tim Davis, investment strategist at consultancy Fathom Consulting, said this was partly down to the reluctance amongst officials to take on credit risk from the private sector. But with Mark Carney at the helm, and given the EU experience, the approach may change. "We think that corporate bond purchases would have a bigger impact on the real economy, and are expecting a £60bn QE programme, with £50bn gilt purchases and £10bn corporate bonds," Davis says.
This view is far from consensual, though. "The UK corporate bond market is functioning reasonably well, and has repriced for Brexit without dislocation," says Axa IM's Page. "Back in 2008, when there was dislocation, the BoE tried to buy corporate bonds as part of its asset purchase programme, but even then they only managed to buy about £1bn, so it is not obvious that they will try to forcefully enter the market now."
Page adds that the BoE is in a different position to the ECB, as the latter has been forced into the corporate bond market by the restrictions it imposed on itself on government bond purchases. "The BoE faces no restrictions. Besides, if we assume that they are going to carry out £200bn worth of QE, that is about 15% of privately held government bonds in the market," he explained. In comparison, he notes that in 2009 QE purchases amounted to about one-third of the bonds in the market.
Targeting duration
Another question that remains unanswered is whether the BoE will target its purchases at specific durations. In the past, it has spread its gilt purchases across all maturities above three years, which had the effect of pulling down the whole of the yield curve. Page expects it to follow the same approach now.
Others concede that a more targeted approach can be taken, which would enable the BoE to influence the shape of the yield curve. "They might decide to buy fewer long-dated bonds," Davis says, noting that this would drive yields in the long-term. "An even better option from the perspective of insurers would be for the BoE to sell long-dated bonds, and buy more short-dated bonds, but this is not our base case scenario," he says.
A focus on short-dated bonds would help to shield life insurers and pension funds from the negative impact of QE, enabling them to preserve some of the returns of investments in long-dated investment grade bonds. But even then the effect would be limited.
"The purpose of monetary policy easing is to lower interest rates, and lower-for-longer interest rates will make things more difficult the insurance industry," Page says.
If there is one thing that analysts agree on is that tomorrow will not be the BoE's final word. If the economy deteriorates, the BoE will be under pressure to cut rates to 0% and expand the size and scope of its programmes.