"Poor Old Sterling": Why Negative Interest Rates will Trigger Further Losses in the Pound's Value

- Negative interest rates being considered says BoE's Bailey
- A bad idea says Société Générale's Juckes
- GBP to remain pressured in negative rates environment

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The British Pound plumbed a fresh 7-week low against the Euro and underperformed the majority of its G10 rivals after the yield paid on UK government debt fell below 0% for the first time in history, meanwhile expectations for further declines in the currency continue to grow on a view that the Bank of England would soon cut interest rates to below zero in an effort to further support the economy.

For the first time ever, bonds sold by the UK government would average a yield of below zero after the Debt Management Office on Wednesday auctioned £3.75BN of gilts (UK government bonds) for maturity in July 2023, with an average yield of -0.003%.

Considering the now non-existent return on government debt, gilts will appear as a highly unattractive investment vehicle for foreign investors.

This matters for Sterling as the currency has over decades derived value from the steady demand for UK government debt from international investors; the negative yield now on offer means the currency has lost a significant pillar of support.

The developments in the UK's debt markets are being reflected by a broadly weaker Sterling; the Pound-to-Euro exchange rate fell to a 7-week low at 1.1126 on Thursday morning, meanwhile the Pound-to-Dollar exchange rate traded back below 1.22 at 1.2190.

Driving the value of government yields to below zero was the muscle of the Bank of England which has been mandated to hoover up government bonds, with the explicit aim of keeping the yields paid on those bonds as low as possible. The yield is the money paid by the government to the bond holder at regular intervals, keeping yields as low as possible therefore lowers the cost of borrowing for the government which now needs to find additional billions of pounds to fund its response to the coronacrisis.

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The buying of government bonds is being conducted under the Bank's quantitative easing programme which sees the Bank print money to buy bonds, meaning the Bank is in effect creating so much demand for the bonds that it is forcing the yield on those bonds ever lower.

This is good for the economy and government, but it is clearly a significant black mark against Sterling.

The foreign exchange market is now increasingly of the opinion that the Bank of England will step up its support for the economy further still, by cutting rates below the current 0.1% to either 0% or below.

The prospect of negative interest rates in the UK will only add to the downside pressure on Sterling according to analysts.

Appearing before parliamentarians on Wednesday, Bank of England Governor Andrew Bailey said negative interest rates are under active review, "we do not rule things out on principle".

He added the Monetary Policy Committee has a history of keeping under review the "lower bound", which is effectively the lowest level of interest rates they are prepared to cut interest rates to.

The comments from Bailey echo those made by the Bank's Chief Economist, Andy Haldane, who over the weekend said in an interview negative interest rates were a possible outcome of future policy decisions.

The green light to cutting interest rates yet further will have come from the latest official inflation statistics that showed UK inflation has fallen further and read at 0.8% year-on-year in April.

"In the UK, inflation has fallen further, with lower transport, fuel, utility and clothes prices outweighing increases in pizza, burger, whisky, lager and games (pre-school and computers/console). It paints a picture of lockdown life, but also keeps the debate about negative rates alive and kicking, all the more so as MPC members are discussing it. Personally, I can't think of an economy where negative rates are a worse idea than the UK," says Kit Juckes, FX Strategist at Société Générale.

A central bank can only cut interest rates and print substantial quantities of money as long as inflation is low; as soon as inflation starts heating up the Bank will have to consider raising interest rates and abandoning its quantitative easing programme again.

But it is not just inflation that could act as a handbrake on the Bank of England's ambitions, the slump in Sterling caused by all this financial wizardry will also have to be considered.

"How much QE they can do depends on how much it weakens the pound. How on earth does it make sense to even consider adding negative rates to the mix? The economic benefits are dubious but the power of a cocktail of negative rates and massive QE to weaken the currency seems clear and if the pound falls enough, it will make QE harder," says Juckes.

A softer Pound is particularly damaging to an economy like the UK's which is a net importer of goods, further declines in Sterling will inevitably push up the cost of living for the British people.

“An even weaker pound will help to reduce people’s purchasing power and a drop in UK living standards. Weaker sterling means imports are more expensive, with rising costs being passed on to consumers,” says Green.

"The fall in the pound is good for exports some claim, but it must be remembered that around 50% of UK exports rely on imported components. These will become more expensive as the pound falls in value," says Nigel Green, Chief Executive of deVere Group. "The fall in the pound is good for exports some claim, but it must be remembered that around 50% of UK exports rely on imported components."

Green adds these components will also become more expensive as the Pound falls in value.

"I'm not quite at the stage standing outside the Bank with a placard, but I might get there. It just goes to show that even when it's a really bad idea, central banks eventually consider negative rates. Poor old sterling!" says Juckes.