Bank of England rate cut presents opportunities in Gilt and FTSE 100 ETFs

Aug 5th, 2016 | By | Category: Fixed Income

The Bank of England (BoE) has cut interest rates to historic lows as part of stimulus measures decided by the Monetary Policy Committee (MPC) during its meeting on 4 August 2016. There was an immediate positive effect on exchange-traded funds tracking UK equity and government bond exposures as Gilt yields dropped and the FTSE 100 jumped on the announcement.

Bank of England

The Bank of England’s Monetary Policy Committee, which met on 4 August 2016, decided to implement a quarter-percent cut in interest rates from 0.50% to 0.25%.

The move to reduce benchmark interest rates was widely expected from market participants following the release of UK activity indicators in the days preceding the meeting that showed the economy starting to lose pace. A study from index provider Markit showed that the UK Business Activity Index suffered its biggest monthly fall during July since the survey began in 1996, with the index losing 4.9 points to rest at 47.4. At midday on Thursday 4 August 2016, the BoE announced that it had cut interest rates from 0.5% to 0.25%. What perhaps caught the market off guard was the extent of further stimulus actions imposed by the Bank.

Wei Li, Head of Investment Strategy at ETF issuer iShares EMEA, commented in a statement: “The Bank of England has delivered more than the already heightened market expectation, both in terms of size of the QE program expansion and the inclusion of corporate bonds in the program – and this showed in the way the market reacted. It is notable that they also kept the doors open for future actions.”

Timothy Graf, head of macro strategy at State Street’s Global Markets division EMEA, offered his views: “Given how far sterling and UK rates had already fallen, surprising the market was always going to be a tall order, but it looks like the Bank of England has done just that. They appear more concerned about the prospect of a deep recession than their inaction last month might have suggested. I am surprised that they decided to implement a number of measures to address the problem at such an early stage, but given the sharp drops we have already seen in the survey data, they likely anticipate more bad news to come.”

Mike Amey, Head of Sterling Portfolios at PIMCO, added: “The Bank of England has revised down its growth forecasts towards zero for the next 12 months. CPI is expected to rise to 2.5% by the end of 2017. These are consistent with PIMCO’s expectations for UK growth and inflation. In response the MPC has cut rates, restarted QE, included corporates in the bond buying programme and initiated a new funding scheme for the banks. In short, the MPC looks to have used all of the tools market participants had been looking at.

“By extending the QE programme over the next six months, and the corporate bond buying programme over the next 18 months, the MPC has indicated that it expects to be in easing mode for a good while to come. This has triggered new lows on UK gilt yields and pushed sterling down again this morning. These moves are justified by what is certainly a comprehensive programme, and will support these levels going forward.”

The yield on UK 10-year gilts, the most widely-quoted reference for UK government borrowing costs, fell 14bps to a record low of 0.67% following the announcement. There are several ETFs covering varying exposures to UK Gilts that benefited from the fall.

Those which offer short-dated Gilt exposure include the iShares UK Gilts 0-5yr UCITS ETF (LSE: IGLS), which has over £970m in assets under management (AUM) and a TER of 0.20%; the db X-trackers IBOXX £ Gilts 1-5 UCITS ETF (LSE: XG5D) which has £5m in AUM and a TER of 0.20%; and the SPDR Barclays 1-5 Year Gilt UCITS ETF (LSE: GLTS), which has £360 AUM and a TER of 0.15%.

Those ETFs covering a broader range of Gilt maturities include the Vanguard UK Gilts UCITS ETF (LSE: VGOV), which has AUM of £160m and a TER of 0.12%; the iShares Core UK Gilts UCITS ETF (LSE: IGLT), which has AUM of £1.6bn and a TER of 0.20%; and the SPDR Barclays UK Gilt UCITS ETF (LSE:GLTY), which has AUM of £135m and a TER of 0.15%.

Additionally Boost ETP offer triple leveraged and triple inverse leveraged exposure to the daily performance of 10-year Gilt yields. The Boost Gilts 10Y 3x Leverage Daily ETP (LSE: 3GIL) and the Boost Gilts 10Y 3x Short Daily ETP (LSE: 3GIS) have TERs of 0.30% each.

The rate cut also had immediate effects on the UK stock market and the value of the pound against major trading currencies. The FTSE 100 Index responded by rising 89.9 points to 6724, but the pound tumbled 1.4% to $1.3134 shortly after the announcement. The FTSE finished the day up 1.5%.

There are several ETFs listed on the London Stock Exchange tracking the FTSE 100 Index. These include the iShares Core FTSE 100 UCITS ETF (LSE: ISF), with over £4.0bn in AUM as of 27 July 2016. It is also one of the cheapest means of accessing the index with total a total expense ratio of just 0.07%. Other significant ETFs referencing the FTSE 100 Index include the Vanguard FTSE 100 UCITS ETF (LSE: VUKE), which holds over £2.2bn in AUM and carries total fees of 0.09%; and the UBS FTSE 100 UCITS ETF (SIX: 100UKD), holding over £140m in AUM and carrying a total expense ratio of 0.20%.

The stimulus measures will be widely seen as not only responsive to slowing economic indicators but as an attempt by the BoE to reassure the market over the health of the UK economy following heightened uncertainty as a result of Britain’s decision to leave the European Union. The result of the Brexit vote has already impacted the country with credit ratings downgrades from major ratings agencies. Standard & Poor’s credit rating for the UK currently stands at AA with negative outlook, Moody’s credit rating for the UK was last set at Aa1 with negative outlook, and Fitch’s credit rating for the UK was last reported at AA with negative outlook.

In general, a credit rating is used by sovereign wealth funds, pension funds and other investors to gauge the credit worthiness of the UK, thus having a big impact on the country’s borrowing costs. Downgrades in rating or changes to a negative outlook tends to increase the yields on government debt, thereby pushing down gilt prices and negatively impacting ETFs tracking the space.

Commenting on the long-term outlook of the UK economy, Peter Westaway, Chief Economist and Head of Investment Strategy Group, Europe, at asset manager and ETF issuer Vanguard, said: “As well as these policy decisions, the Bank has released the latest Inflation Report which reveals its new forecasts showing a sharp downgrade to the growth forecasts, showing the UK economy at or close to recession, while the forecast inflation rate is expected to return more quickly to the 2% target and overshoot during 2018. These represent the largest quarterly revision to their forecasts since the MPC was formed.

“…Of course, there is still relatively little hard data to validate these pessimistic forecasts. The PMIs released in the last week suggest that GDP growth could turn negative in the third quarter, that is worse than the Bank is projecting. And evidence from the Bank’s network of agents around the UK suggests that the UK economy is set for a sharp fall in capital expenditure and hiring across a range of industries and a range of expenditure categories, most notably survey-based evidence in the Bank’s Inflation Report.

“Overall, the Bank’s response reiterates the widely held concern that the UK economy is set for a sharp slowdown, notwithstanding the fact that the fall in the exchange rate and this policy response will “blunt” the impact of the shock to to the UK economy.”

While UK Gilts may absorb the most immediate impact from the rate cut, Wei Li of iShares explains that the policy will be felt throughout several asset classes due to the effect on the value of Sterling: “In terms of what this development means for investors: in equities, on a relative basis large caps could outperform mid-and small-caps because they have more diversified revenue growth model in a weak Sterling environment. UK investors could consider leaving international exposures unhedged and international investors could consider hedging their UK exposures. From a fixed income perspective, limited supply and the newly announced 18-month corporate bond-buying programme could support UK credit.”

The BoE’s stimulus measures will likely cause impacts that ripple out to other asset classes over time. Due to the high liquidity of the ETF structure, the ETF industry will continue to be a highly informative source as to how investors respond over the coming days to the Bank’s decision. “More broadly, we tend to see investors using ETFs to adjust their portfolios, to access markets and sectors quickly following announcements such as today’s. The flows will therefore be interesting to monitor over coming days,” Wei Li said.

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