Mr Carney’s speech and money rates

Mr Carney’s first speech was important in three respects.

First, he emphasised the importance of the Bank Rate, and well he might given that over 70% of loans to households and more than 50% of loans to businesses are linked to the Bank Rate, and on the path for rate rises, Mr Carney emphasised that there is “only a 1-in-3 chance of unemployment coming down that quickly” (as quickly as mid-2015), suggesting that the market is too optimistic that rates will rise quickly.

Secondly, he made a differentiation between long-term yields and market rates prevailing for the period between 2 years and 5 years. He acknowledged that the market has brought forward expectations of a Bank Rate rise from end-2015 to mid-2015, but determined that this was not a major concern for the Bank of England (BoE).

Thirdly, there was the announcement on the change for the liquidity ratios for banks and this highlighted the BoE’s preference for credit easing over quantitative easing. Thus, the BoE announced that for banks and building societies with a minimum capital ratio of 7%, and a 3% minimum of capital to total assets, there will be a reduction in the required liquid asset holdings. The reason to do this was to help the flow of credit to the real economy. We can read this last comment as a new “stimulus” measure, which serves to negate any immediate need to cut Bank Rate or to expand QE and interestingly if we look at UK banks’ holdings of gilts, it’s noteworthy that they have been trending upwards this year, especially in 5-25y maturities, while loans to the “real economy” have been quite stagnant.

From first principles, the reduction in liquidity ratios, and therefore the requirement to hold gilts, in effect releases bank cash for more lending, but with negative implications for gilts, and indeed gilts sold off and the yield curve steepened on Mr Carney’s announcement. We may expect actual implementation of the policy to weigh further on gilts, especially the 5 year to 25 year range that banks have been accumulating this year.

Having said that, despite the caveats from Mr Carney and the strengthening data, there is still a good case to be made that front-end rates are too high, and pricing in a faster normalisation in policy rates than we and the BoE expect. Thus the GBP ‘1y1y’ rate is implying over a 30bp rise in 1 year money rates in one year’s time. While rate hikes in 2014 are possible, we may suspect that the market has discounted guidance too far and we may expect a reversal in the near term – especially if the situation in Syria escalates further. If we think about what this may mean for spreads, it may be that the 1 year to five year curve has more steepening in prospect than the 2 year to 10 year curve which at the recent level of 198bp is already taking much ‘on the chin’.

In trying to gauge what the market’s really thinking, it is possible to model the implied tightening built into the Sterling Overnight Interbank Average Rate (SONIA) curve using a gamma and exponential distribution, and on this basis, the market has been gradually shifting the expected date of the first rate hike from September 2015 to March 2015. This reveals that the market is expecting tightening earlier and earlier. Interestingly, the market is now expecting tightening to start earlier in GBP than in USD, although frankly this stance looks unjustified in the context of current and projected future economic and monetary conditions.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla