Market Bets for Negative BOE Rates Back as Banks Weigh Chances

(Bloomberg) -- Renewed warning signs on the prospect of negative interest rates at the Bank of England are showing in the market as traders and analysts look again at the chances of such a move.

One investor bought 25,000 options Thursday on three-month interest rate futures that will pay off if the BOE eases below zero by September. The trade could also be profitable if the central bank holds rates steady, but it strongly hints at further cuts by the year-end. The bet will pay out almost 4 million pounds ($5.1 million) if rates fall below zero by September.

Analysis from Morgan Stanley sees the base rate reaching zero in November with the central bank potentially cutting further in 2021. Increased chances of it going sub zero are helping HSBC Holdings Plc find continued appeal in U.K. bonds.

For now, investors in U.K. debt appear to be positioning for more economic stimulus rather than rate cuts. Money markets are currently priced for base rates to stay above zero by summer 2021, although moves here have been dramatic over recent months.

They tracked dovish comments from U.K. policy makers, as central banks around the world sought to limit the economic impact of coronavirus. Then, the prospect narrowed after BOE Executive Director for Markets Andrew Hauser said negative rates were not going to happen in the near term.

The policy is controversial, and its use in the U.K. would be subject to a particular blend of risks.

Sub-zero rates could have a significant impact on financial companies, which make up a major part of the country’s dominant service sector. A key concern is the impact on banks’ profitability, at a time when the margins on their loans are tightening as borrowers struggle to remain viable.

The latest standoff in Brexit talks and concerns about a potential second wave of the coronavirus have brought attention back to the debate.

The BOE could reduce rates as far as minus 50 basis points in the first half of 2021 according to Jacob Nell, a London-based economist at Morgan Stanley, although he only puts the chances of that at 20%, “if we have a hard Brexit or bad Covid,” according to emailed comments.

Such action would come in two stages during February and May 2021, Morgan Stanley’s analysis said. That puts it ahead of the money markets, where investors bet that rates will only have fallen to near zero by summer 2021.

Lines of Defense

The central bank has several other lines of defense, including more stimulus and cheap lending to banks, which it could use before it cuts below its record low of 0.1%. Yet it could be forced to act if intensive quantitative easing fails to help the economy out of a historic recession. In March, the BOE announced it would add 200 billion pounds of gilts ($253 billion) and corporate bonds to its asset-purchasing program, expanding it by 45%.

Morgan Stanley expects the BOE to top up its asset-purchase facility with 100 billion pounds in gilt buying next week. It may announce a further 100 billion increase to QE in November -- even as this becomes less effective, Morgan Stanley said.

The BOE could also step up its Term Funding Scheme, which provides cheap money to banks in an effort to stimulate lending to the economy.

What Bloomberg Intelligence Says

“‘The BOE’s constructive ambiguity on negative rates is helping keep yields pinned and encouraging speculation in market pricing. QE is the preferred tool for now. Negative rates on the Term Funding Scheme seems more plausible first, essentially paying banks to take funding rather than hitting their profitability.”

-- Tanvir Sandhu, Chief Global Derivatives Strategist

HSBC Holdings Plc lowered its forecast for gilt yields this year to zero, and sees an increased possibility of negative rates. If the bank rate was cut to negative, there is still room for yields to fall further given the possibility of even deeper reductions, Daniela Russell, HSBC’s head of U.K. rates strategy, wrote in a client note.

A cut could pile further risks onto the pound, which has underperformed most of its Group-of-10 peers this month. Sterling snapped 10 days of gains on Thursday, falling as much as 0.8% to $1.2651.

“If there is a second wave this autumn I have little doubt rates could sink to or below zero,” said Kenneth Broux, a strategist with as Societe Generale SA in London. “Medical experts seem to be quite convinced that it will happen after the summer.”

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