What would negative sterling interest rates mean for UK money market funds?

Bank of England. Photo (cropped) by Bank of England, Flickr.

Sponsored article: Paul Mueller argues there are “few potential alternatives to money market funds for those where capital preservation and daily liquidity remain paramount.”

The significant impact of Covid-19 on the global economy has led governments and central banks to take unprecedented action to support economies and markets. In the UK, the Bank of England (BoE) cut its Bank Rate to an historic low of 0.1% in March 2020. At the time, the BoE viewed this as the “effective lower bound”, below which any further reduction in interest rates would be deemed ineffective, or even counterproductive.

What are the chances of a move to negative rates?

At the 3rd February Monetary Policy Committee (MPC) meeting the BoE surprised markets delivering a more upbeat view of the UK’s recovery prospects. The BoE highlighted that although they are tasking Banks to prepare for the prospect of negative rates this does not necessarily imply they are going to implement them.

The results of a review by the Prudential Regulatory Authority, into the potential impact of negative rates, concluded there could be operational risks to banks if they did not have at least a six-month period to prepare for negative interest rates. As a result of the latest BoE views and progress on Covid-19 vaccinations, markets have reduced expectations for negative rates to just a small risk in the first half of 2022.

Recent UK data has also been a little better. The manufacturing Purchasing Managers Index (PMI), which measures economic trends, was revised to 54.1 in January 2021, from a preliminary of 52.9. (A PMI above 50 represents an expansion versus the previous month, while under 50 represents a contraction).

The final services PMI for January printed at 39.5, a notable upgrade on the flash estimate but still its weakest level since May 2020. The data point to continuing challenges in the UK labour market, potentially weighing on the recovery even as restrictions are eased. However, the latest provisional estimates for Q4 GDP came in higher than expected putting fourth quarter year-on-year GDP at -7.8% (versus -8.6% previously).

Invesco Global Liquidity team’s central case view continues to be that we do not expect negative UK interest rates. However, in these unprecedented economic times they cannot be ruled out completely. The key will be how the economy performs when Covid-19 restrictions are eased, or removed, and how vaccinations move the population towards “herd immunity”. The labour market will obviously be important and the unwind of furlough schemes will be one to watch.

How could a negative rate impact the yield on sterling money market funds (MMFs)?

Regarding the effect on MMFs if sterling yields did go negative, under the latest regulations for European MMFs which went into effect in 2019, the Reverse Distribution Mechanism (which allowed the cancellation of fund units to offset negative returns) is no longer permitted. As a result, MMFs with a negative yield can effectively only be offered using accumulation classes. Accordingly, all investors would need to be moved to corresponding accumulation classes. Unlike distribution classes, which typically transact at a price of 1.00, an accumulation class transacts at a variable price, which moves in line with daily yield.

What are the alternatives to potential negative rates?

Unless investors are willing and able to take additional risk (either higher credit risk, lower liquidity or a combination of both), there are few potential alternatives to MMFs for those where capital preservation and daily liquidity remain paramount.

For investors who can segment their liquidity into longer-dated tranches, we are seeing some explore other pooled funds, including exchange traded funds. Understanding how these funds are managed is essential for investors to identify products that meet their needs.

Paul Mueller is head of global liquidity, EMEA portfolios, Invesco Global Liquidity.

Photo (cropped) by Bank of England, Flickr.

INVESTMENT RISKS: The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. An investment in a money market fund (MMF) is not guaranteed. An investment in a MMF is different from an investment in deposits and is capable of fluctuation; as a result, investors may not get back the full amount invested. A MMF does not rely on external support for guaranteeing the liquidity of the fund or stabilising the net asset value (NAV) per unit or share. The risk of loss of the principal is to be borne by the investor.

IMPORTANT INFORMATION: Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. Issued by Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.