Bond Market versus BoE Base Rate

stueyhants

Generali wrote: »

The base rate (AIUI) is what used to be called the Repo Rate.

A Repo is a kind of transaction between banks when one bank lends another money secured against Gilts. For example, Stueyhants Bank might want to borrow £1,000,000 from Generali Bank. Stueyhants Bank delivers £1,000,000 worth of bonds and Generali Bank lends £1,000,000 to Stueyhants Bank for an agreed period (say a week or a month) and charges a rate of interest. When Stueyhants Bank repays the money, it gets the Gilts back. If it defaults, Generali Bank can sell the Gilts to get its money back.

Now the BoE will enter into Repos with banks in the UK and the rate of interest it uses is the Base Rate I believe. Now take an example where the base rate is 0.5% but 1 year Gilt yields are 2%. Stueyhants Bank can buy £1,000,000-worth of Gilts and then enter into a 1 year repo with the BoE* so Stueyhants Bank ends up having its million quid still which it can use to do something profitable.

At the end of the year, Stueyhants Bank repays the debt + interest which is £1,005,000 and gets its Gilts back. At this point, the Gilts mature and Stueyhants Bank gets £1,000,000 as principal sum back plus £20,000 in interest, a £15,000 guaranteed profit. Clearly, that isn't a trade that can be allowed to continue for long unless you're printing the money to pay the banks.

So now you should think about what follow-up question you want to ask about QE.

*I know IM and others, a 1 year repo with the BoE is unlikely but this is an example so I'm trying to keep it simple.

But if Base rates are not put up what happens, credit stops ?

Generali

stueyhants wrote: »

But if Base rates are not put up what happens, credit stops ?

Well there's a steady loss to the BoE which ultimately would lead to the BoE becoming insolvent or the Government having to give the BoE more money.

There are a limited number of Gilts in circulation so there is a limit to the trade.

HammerSmashedFace

Cleaver wrote: »

A young couple buy a house now and get a mortagage with a low interest rate. The worst case scenario is that they buy a house now, then over 25 years they never get a different job and rates rise to 8% for years. Is this really likely? Or will there be a variety of interest rates over the next 25 years based on the economic climate of the time? And will the people remain on the same salary for 25 years? I doubt it. They'll get promotions, new jobs, maybe get made redundant, maybe get some inheritance, probably have kids and have to cope on one income for a while, maybe do really well in their career and earn a lot of money... there's so many variables. It's always been like this and people cope.

Of all the people I know there is a very, very small number who get one job and stay in it for years and years. Most people, probably motivated deep down by boredom, tend to work their way up in to better jobs: some at a quick pace, some more steadily.

Why do you always base future outcomes on the complete worst case scenario? What you've described above will happen for some of the unfortunate few who aren't financially savy or fall on hard times, but the majority will probably be okay, rather than it all 'ending in disaster'.

You makes some fair points as always Cleaver, however look at the news this week, repo's the worst for 15 years, and that's with all the government help, schemes, lo IR's etc, £200 billion QE, £300 billion bank backing etc... Repo's would almost certainly broke the 150,000 barrier without these schemes (300,000 in 3 months arrears now, and thats with the help) all well and good if these schemes were free, or cheap, however they are going to cost us dearly in the long run.

Cleaver

HammerSmashedFace wrote: »

You makes some fair points as always Cleaver, however look at the news this week, repo's the worst for 15 years, and that's with all the government help, schemes, lo IR's etc, £200 billion QE, £300 billion bank backing etc... Repo's would almost certainly broke the 150,000 barrier without these schemes (300,000 in 3 months arrears now, and thats with the help) all well and good if these schemes were free, or cheap, however they are going to cost us dearly in the long run.

Okay, but how dearly? Translate this to the real world, to the people buying houses at the moment. How do you think it will effect them as a whole over the next 25 years?

I'm sitting here in rose-tinted glassed or anything, I pretty much agree with you that this country is in a mess. I reckon we're in for a very hard decade with high taxes, cuts in public services, a very tough employment market and very little rises in wages. I think all people, especially those in their twenties and early thirties, will have a cold, sharp shock with the next decade. I'm past trying to predict anything, but I wouldn't be surprised to see a 'lost' decade with house prices, the stock market and wages staying flat (so effectively going down each year). Add this to the higher taxes and we're in a bit of a depressing state.

However, I don't see why most people won't be fine. And to take it one step further, maybe it's not a bad thing. Jobs will still be available for people who really add value, or are particulary good or innovative at what they do. People are talented and shrewd with the stock market or property will always make money, but those looking to make a quick buck out of any rising market will probably struggle. Society will probably change, people's attitutes will change and maybe we won't see another 'bling' decade like the last one.

Most people buying house now will be just fine, just as people buying houses through the last 60 years have been fine. Some will borrow too much, or be cr*p with their finances, but most won't. 'Tis my opinion anyway.

Cleaver

globalds wrote: »

That is generally considered the right way to do it.

If you were planning a long journey the last thing you would want to hear as you cast off your moorings would be the shout from shore " As long as you don't get any rough sea you will be fine".

As the old saying goes ...Plan for the worst , Hope for the best.

You don't plan for every scenario on the basis of the very worst happening though, do you? To take this back to mortgages, the worst scenario that could happen to me and my wife is that we both lose our jobs and cannot get another one for years. If this happens we get our house repossessed. On this basis if we planned for the worse we wouldn't ever buy a house, and nor would anyone else unless they could buy it outright.

What you do is look at the risks and try and mitigate them as best you can. You have a fund that covers you for 6 months when required, you overpay where you can, you factor in your mortgage when moving jobs, you make sure you don't go on 5k holidays and you don't buy a house that takes up a massive percentage of your salary.

You go in to buying a house knowing that there is a small risk that you could get it repossessed. However, you mitigate this risk by being sensible. Which is pretty much how everyone lives most aspects of their life.

At the risk of sounding a bit snipey, there are a few on here that have trouble seeing the world as anything but the worst case scenario always happening to everyone, all of the time. It's just not realistic.

purch

Give that, does the BoE have to change base rate to mirror the ‘real’ money market rates? Can the disconnect between Base rates and LIBOR (1,5,10 year … etc) grow wider, are there any consequences ?

Yes there are consequences, a yield curve as steep as it is now, is an expensive consequence for the BOE, but this is a price that the 'powers that be' deem worth paying, rather than the alternative which would be a higher base rate currently.

Jonbvn

Cleaver wrote: »

What you do is look at the risks and try and mitigate them as best you can. You have a fund that covers you for 6 months when required, you overpay where you can, you factor in your mortgage when moving jobs, you make sure you don't go on 5k holidays and you don't buy a house that takes up a massive percentage of your salary.

Cleaver what happened? Have you got your sensible hat on today?

You are correct that anyone should identify "reasonable" risks and how to mitigate them. I seem to spend most of my professional life in meetings to address this same issue. If I was a uberbear, no doubt I would be identifying asteroid strikes as significant hazards;)

GDB2222

Generali wrote: »

The base rate (AIUI) is what used to be called the Repo Rate.

A Repo is a kind of transaction between banks when one bank lends another money secured against Gilts. For example, Stueyhants Bank might want to borrow £1,000,000 from Generali Bank. Stueyhants Bank delivers £1,000,000 worth of bonds and Generali Bank lends £1,000,000 to Stueyhants Bank for an agreed period (say a week or a month) and charges a rate of interest. When Stueyhants Bank repays the money, it gets the Gilts back. If it defaults, Generali Bank can sell the Gilts to get its money back.

Now the BoE will enter into Repos with banks in the UK and the rate of interest it uses is the Base Rate I believe. Now take an example where the base rate is 0.5% but 1 year Gilt yields are 2%. Stueyhants Bank can buy £1,000,000-worth of Gilts and then enter into a 1 year repo with the BoE* so Stueyhants Bank ends up having its million quid still which it can use to do something profitable.

At the end of the year, Stueyhants Bank repays the debt + interest which is £1,005,000 and gets its Gilts back. At this point, the Gilts mature and Stueyhants Bank gets £1,000,000 as principal sum back plus £20,000 in interest, a £15,000 guaranteed profit. Clearly, that isn't a trade that can be allowed to continue for long unless you're printing the money to pay the banks.

So now you should think about what follow-up question you want to ask about QE.








*I know IM and others, a 1 year repo with the BoE is unlikely but this is an example so I'm trying to keep it simple.

Unsurprisingly, what seems to have happened is that gilt yields have rearranged themselves to fall in line with the repo rate. You can pick up the gilt yield curve here:
http://www.bankofengland.co.uk/statistics/yieldcurve/

At the very short end, the gilt yield is 0.52% pa. At 12 months, gilt yields are 0.71%. I'm not sure how you GeneraliBancorp would do this risk-free over 12 months as the repo rate is not guaranteed that long?

I guess the 0.71% figure over 12 months can be interpreted as the market expecting a rise in repo/base rate over that period. Or is that too simplistic?