Article / 03 August 2016 at 23:43 GMT

Aggression required from the BoE as economy slows

Managing Partner / Spotlight Group
United Kingdom
  • The UK economy is contracting at its fastest rate since the financial crisis
  • A reduction of 25 basis points in the base rate alone will be insufficient
  • Serious bank stress tests would be constructive
  • The BoE Governor needs to be a 'Carney'vor

By Stephen Pope

The UK economy is, despite the recent words of the new Chancellor, not looking too good. I am all for talking up the British case, however, there comes a time when such unabashed optimism is indefensible. 

The reason for saying this is because the Markit/CIPS Purchasing Managers' Index showed activity in the UK's dominant services sector (79% of GDP by value) experienced its sharpest fall in seven years.

The index fell from 52.3 in June to 47.4 in July, indicating a contraction and confirms the earlier flash estimate. It comes after falls in both construction and manufacturing in July, which all contributes to a flat-lining growth rate of GDP and one should expect the level of capacity utilisation to fall back below 80 by the end of the year.

Source: Markit, Office for National Statistics 

The four statistics illustrated in the chart above would suggest that a reduction in the base rate by the Bank of England’s Monetary Policy Committee from 0.50% to 0.25% is now fully discounted.

Following the services PMI Markit, when they also reported that incoming new business volumes fell for the first time since the end of 2012, they said that a rate cut: was a foregone conclusion".

What is clear from the top left panel in the chart is that the pace of contraction in services broke the slope or pace of the established correction, i.e. it was a considerably sharper reduction in activity and was marked as the most rapid decline in activity since March 2009.

Of course the surprise European Union referendum result had played a part in slowing new business inflows; the service sector data taken with the manufacturing and construction data implies that the UK economy will endure a contraction of 0.4% during the current quarter.

The BoE should insist that the full measure of any rate reduction be
passed onto the public – unlike what happens in Australia. Photo: iStock

Radical central banking required

This is no time for the BoE to pussy foot around the question of reducing interest rates. I know we will get just 25 basis points off the base at best, after all Governor Mark Carney will act with the natural caution of a gradualist central banker.

Still, this is a platform to be forthright and I would be delighted to see the Governor become ultra-aggressive and deliver a full 50bps to take the base rate to zero. Why not? There is nothing to say he cannot go the extra mile. Simultaneously he should increase the scale of quantitative easing from the level of £375 billion and signal £500 billion, i.e. add £125 billion of new money in its QE programme.

However, it is not just in monetary policy that Carney needs to act boldly. A key lesson can be learned from recent Australian history where the commercial banks have been guilty of only passing onto the public half of whatever rate cut the Reserve Bank of Australia has delivered. As the central bank of the UK, the BoE has to insist that the full measure of any rate reduction be passed onto the public as individuals and businesses.

While dealing with the commercial banks it has to be recognised that the BoE has not crafted a rigorous enough stress test programme for the commercial banks operating within the UK. It is a sad fact that most of our banks would come up as inadequately capitalised if subjected to the percipient examination deployed by the US Federal Reserve.

The BoE claimed that the UK’s major banks and building societies passed last year’s stress test, which subjected them to losses twice those incurred during the global financial crisis. This is not how the Adam Smith Institute sees it, saying the Bank of England’s stress tests are worse than uselessand that the UK is “sailing blindly into a second global financial crisis”.

This is not a single view. Kevin Dowd, Professor of Finance and Economics at Durham University, said: "...The purpose of the stress-testing programme should be to highlight the vulnerability of our banking system and the need to rebuild it ... Instead, it has achieved the exact opposite, portraying a weak banking system as strong. This is like having a ship radar system that cannot detect an iceberg in plain view ... As the EU banking system goes into a renewed crisis, the UK banking system is in no fit state to withstand the storm ... Once contagion spreads from Italy to Germany and then to the UK, we will have a new banking crisis but on a much grander scale than '07-'08.”

Widen UK QE without delay

Critics of QE will argue that the last thing that is required is an even greater distortion in the shape of the UK yield curve or measures that may harm the level of liquidity in the sterling bond and money market and thus impair the process of price discovery in UK asset markets. Of course yields have fallen, as the chart of yield changes shows, however, the UK is not out of line with other large and liquid government bond markets.
UK Gilt Yields
Source:, Debt Management Office and Spotlight Ideas
UK Gilt Spreads

Source:, Debt Management Office and Spotlight Ideas

The curve has flattened from the 2 to 5, 2 to 10 and 5 to 10 year sections, although in the past year the spread of the 5 to 10 year gilts has been steady 45.0 bps to 44.7 bps.

The greatest beneficiary of the QE programme has been the 10-year gilt as the yield has fallen by 258.6bps since QE really swung into action. So now is it not time to widen out the areas in which QE can be applied in an attempt to get ahead of the recessionary forces that threaten the economy.

This can be done by the BoE acquiring exchange-traded funds and real estate investment trusts and finally acquiring the last pools of high coupon gilts while passing the semi-annual coupon receipts back to the Treasury, who in turn can issue new gilts at coupon rates more in line with the shape of the yield curve out to the longest maturity and beyond.

Conventional gilts have a specific maturity date and in recent years the government has concentrated issuance of conventional gilts around the 5, 10 and 30-year maturity areas. In May 2005 the Debt Management Office issued a new 50-year maturity conventional gilt and in June 2013, following market consultation, the DMO issued a new 55-year maturity conventional gilt.

Why not go longer and have paper out to 75 or even 100 years? The US Treasury has considered issuing a century Treasury. Such paper would, given a low coupon carry a duration that would be approximately 90 years and offer an intrinsic appeal to the insurance industry that need long-dated assets on their books. Issued in a large enough size, the issue could become as iconic in the bond market as is the US Treasury 30-year long bond today.

High quality paper of this nature is not available, in short it is a maturity area that is under populated. In 2015, Mexico sold the first 100-year sovereign bond and in March Ireland sold a €100 million 100-year bond at a yield of 2.35%. They were quickly followed by Belgium who had success with a century bond in April.

 Banking on Carney ... the BoE Governor needs to take bold action in order to fix
the UK's slowing economy. Photo: Flickr

Supporting government spending

I am not in favour of the left-wing notion of “People’s QE”, i.e. a new wave of government debt that is snapped up by the central bank so that the money can be directed to grandiose schemes of public works. This is not a good use of central resources or state borrowing. 

Governments waste money and cannot resist the largesse of jobs for crony supporters. If the trade unions are too heavily empowered, then projects will be held to ransom and endure expensive cost overruns. In such hands the concept of 100-year debt deals would be the new financial weapons of mass destruction.

The most radical way the BoE can step up to the plate and help create the conditions to ward off recession is to slash rates and see the benefit passed on by banks that are fit for purpose. The mission has to be widening the remit of QE, make it a broad as it is deep. That will also entail the active acquisition of old higher coupon gilts, wash to coupons through to the Treasury and pave the way for a entire new gilt yield curve to be created that carries current coupons in line with their yields to maturity.

A sound economy has to be underpinned by sound sovereign finances and a central bank that can be as proactive as it is independent. Please be bold Dr Carney, we are “banking” on you.

– Edited by Gayle Bryant

Stephen Pope is managing partner at Spotlight Ideas. Follow Stephen or post your comment below to engage with Saxo Bank's social trading platform.
Michael Liu Michael Liu
Hi Stephen, can we short GBP/USD ?
Jim Earls Jim Earls
How does one cut their already low rates with their currency near 30 year lows vs. USD?
Stephen Pope Stephen Pope
Hi Michael,

Yes...I am short GBPUSD, but from earlier at 1.31 I am suffering at the moment...but I believe GBP will decline.
Stephen Pope Stephen Pope

One cut of 25bps is inadequate...far more needs to be done...but not by state intervention through vast swathes of state expenditure.

Low rates, more liquidity and supply side policies are needed.


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