Treasury Today Country Profiles in association with Citi

Interest rates: little room to manoeuvre

Fragile card tower

The Bank of England cut its benchmark interest rate to 0.5% back in March 2009. Last week’s decision to raise it above this emergency level is a small step back to normal conditions and its durability looks fragile.

UK corporate treasurers hoping the Bank of England (BoE) might offer clarity on the future direction of interest rates are likely to have been disappointed by last Thursday’s announcement. As many had expected, the base rate rose by 0.25% to 0.75% – the first time that the bank’s benchmark has been above 0.50% in almost a decade. The one surprise was that the decision by the nine members of the monetary policy committee (MPC) was unanimous, with no dissenting voices on the need for an increase.

The reason offered was that the MPC believes the UK economy can withstand slightly higher borrowing costs at a time when unemployment is at a 43-year low and pay deals are beginning to edge higher. However, having downgraded its forecast for this year’s UK economic growth from 1.8% to 1.4% only three months ago, a bounce back to 1.8% is still pencilled in for 2019.

“A quarter-point increase is a small change and will have little impact but the question is whether it was even needed,” says Robert Wood, chief UK economist for Bank of America Merrill Lynch (BofAML). “While it will slow wage growth and hopefully keep inflation lower, the main issue is whether the economy is strong enough. UK growth is currently at a six-year low and over the past decade productivity has consistently been poor.”

As The Times noted, loose credit conditions have exacerbated the problem. “Companies have been kept on life support that in more normal conditions of tighter credit might have gone insolvent. When the cost of capital is low, the penalty for inefficiency is small”. Various estimates put the number of so-called UK ‘zombie companies’ at anything between 40,000 and 100,000 and a quarter-point rate hike is unlikely to prove the death knell for more than a handful.

So will higher rates spur treasury departments into reviewing their company’s funding and investment policies? “Most organisations already operate a flexible investment policy; however more significant market and regulatory changes – such as rising interest rates or the European Money Market Reform – are great triggers to update these policies and reaffirm alignment to corporate investment goals,” says Henrik Lang, BofAML’s head of liquidity, GTS EMEA.

“Preservation of capital and access to liquidity remain the primary objectives of corporate investment policies, although yield is also becoming important. Rising interest rates provide an excellent opportunity to ensure treasurers are maximising the return on their surplus liquidity and we’ve intensified our discussions with clients on this.”

A puzzling change

Given the uncertain times ahead as the UK exits the European Union next March, Wood questions the BoE’s growth projections and its decision – as did the British Chamber of Commerce and the Institute of Directors, which respectively warned that the rate hike was “ill judged” and had “jumped the gun”. While recent speeches by individual MPC members had strongly hinted that a more hawkish tone was developing, he is bemused by the shift in attitude.

For example, former ‘dove’ Sir Dave Ramsden opposed last November’s decision to restore the base rate from 0.25% to 0.50% after it had been trimmed shortly after the pro-Brexit referendum vote “yet nine months later he is siding with the hawks on the basis of next to no information.”

The BoE has indicated that this month’s increase isn’t likely to be replicated within the next year. Indeed, given trade secretary Liam Fox’s warning of increasing odds that the UK will crash out of the EU without having reached any trade deal, the Bank’s next move could even be to rescind the 0.25% hike instead of it marking the first in a series of phased increases.

However, Wood points to the earlier post-crisis decisions by the Bank of Japan, the European Central Bank and Sweden’s Riksbank to nudge rates higher – all of which proved premature. Not only were the rises swiftly reversed, but the subsequent reductions were sharper than expected and took rates to zero or even into negative territory.

Yet neither does the BoE – or the European Central Bank, which has said its benchmark rate will stay at zero for at least another year – have the luxury of following the lead of its US counterpart. Across the pond, the US Federal Reserve has been steadily imposing a series of small incremental rate hikes. A prolonged US economic revival that has now lasted nearly nine years enabled the Fed to exit its US$4.5trn quantitative easing (QE) programme in late 2014 and the first 0.25% hike in the benchmark to a 0.25-0.50% target range came just over a year later.

In all there have been seven quarter-point hikes since December 2015, the latest in June, and at least two more are likely before the end of 2018. That expectation convinced CVS Health to announce plans last March for a US$40bn corporate bond offering – the third-largest debt financing in history – to finance its US$69bn acquisition of Aetna.

“We expect further rate increases from the US, where growth is much stronger and has had the benefit of fiscal stimulus, whereas the UK continues to suffer from uncertainty, which acts as a drag on growth,” says Wood. However, coming at a time of near full employment in America last December’s decision in the US corporate tax rate from 35% to 21% risks the Fed’s tightening policy accelerating.

William Chesney Martin, the Fed’s ninth chairman, famously described his job as “to take away the punch bowl just as the party get going” but the Trump administration is apparently ready to return it with the party in full swing.