Stress Testing a Bank of England Rate Increase

At the next meeting of its Monetary Policy Committee (MPC) on November 2, the Bank of England (BoE) is expected to raise interest rates by a quarter point to 0.5 percent. This would be the first rate increase by the BoE in more than a decade. 

The aim of a rate hike is to restrain economic growth and curb inflation, which in September hit a five-and-a-half year high of 3.0% in the UK. The current inflation overshoot is due to a one-off hit from sterling’s sharp fall after last year’s Brexit vote, and although the BoE believes this effect will soon start to fade, stronger economic growth is expected to re-ignite inflationary pressures. BoE research estimates that a 1% rate increase would lower the inflation rate by 1% after three years, so a quarter-point hike would only put on modest downward pressure on prices. 

The UK economy is growing at around 0.3% on a quarter-over-quarter basis, below its long-run average of almost 0.5%. BoE research has shown that raising rates by 1% would have reduced output by 0.6% over a two to three year period; a quarter-point rise would trim a modest 0.15% from GDP. 

At the September MPC meeting, the BoE hinted that it was likely to tighten monetary policy “in the coming months.” In the 24 hours following these comments, the GBP gained 4 cents against the USD. This means that a November rate rise is already nearly completely priced into the GBP/USD exchange rate and the pound is likely to rise only slightly on November 2 if the BoE raises rates as expected. 

What Would a Rate Hike Mean for Investors?

In order to see how a rate hike would affect investors, we ran a stress test to measure the impact of a hypothetical 25bps increase on the 2Y tenor along the UK yield curve.

The idea is to evaluate stress test scenarios using two different approaches: time-weighted and event-weighted. We used a simple portfolio based on UK gilts (using the BofA Merrill Lynch UK Gilts as a proxy) for euro investors, using two different risk models, the daily Monte Carlo multi-asset class risk model and the monthly multi-asset class linear model.

FactSet Monte Carlo Multi-Asset Class Risk (EUR) Daily

 
The chart above displays the impacts of a 25bps increase in the 2Y tenor rate along the yield curve according to the various scenarios using the Monte Carlo risk model:

• The green line represents the current UK treasury spot yield curve.
• The blue line represents the UK treasury spot yield curve as per the time-weighted stress test scenario. In this case, the entire curve shifted almost completely due to the strong correlation among tenors.
• The yellow line represents the UK treasury spot yield curve as per the event-weighted stress test scenario. Note that the curve is twisted--the short end drops with respect to the 2Y tenor and the long end shifts upward due to the correlation among tenors.

As expected, the euro investor’s portfolio is only exposed to the UK treasury yield curve and the British pound.

Using the FactSet Monte Carlo multi-asset class risk model and relying on more recent covariance/correlations among the risk model’s factors (i.e. time-weighted approach), we see the portfolio would lose 82bps largely due to the long-end exposure to the UK yield curve. However, as expected, that loss is partially smoothed by a currency gain that contributes 1.94% to the overall portfolio result.

With the event-weighted approach (which relies on historical covariance/correlations among the risk model’s factors in the portfolio), the loss is of 94bps, greater than with the time-weighted approach. In this scenario, the GBP gains were just 45bps, much smaller than with the time-weighted scenario, which explains why this portfolio performed worse.

FactSet Linear Multi-Asset Class Risk Monthly

The chart above displays the impacts of a 25bps increase in the 2Y tenor rate along the yield curve according to the various scenarios using the linear risk model:

• The green line represents the current UK treasury spot yield curve.
• The blue line represents the UK treasury spot yield curve as per the time-weighted stress test scenario.
• The yellow line represents the UK treasury spot yield curve as per the event-weighted stress test scenario.

The curve shifted higher in both scenarios due to correlation among tenors; however, compared to the Monte Carlo risk model, the medium/long-end of the curve shifted more and the short-end shifted less.

As with the Monte Carlo risk model, the euro investor’s portfolio is only exposed to the UK treasury yield curve and the British pound. Exposure did not change between the two models. 

With the FactSet linear multi-asset class risk monthly model and relying on more recent covariance/correlations among risk model’s factors (i.e. time-weighted approach), the portfolio would lose 139bps, again largely due to the long-end exposure to the UK yield curve. As expected, that loss is partially smoothed by the currency gain that contributed 78bps to the overall portfolio result. 

With the event-weighted approach, which relies on historical covariance/correlations among the risk model factors, the portfolio loss is 87bps, greater than with the time-weighted scenario. The GBP gain was 64bps, just 10bps less that the time-weighted approach and the overall loss across the yield curve tenors was lower than with the time-weighted scenario. The British pound shows a positive correlation with both approaches, with just some minor differences. 

Despite the differences between the two risk models analyzed here, the FactSet Monte Carlo daily risk model and the FactSet linear risk model, both models behaved well in these scenarios and the results are in line with economic expectations. Both models demonstrate that a 25bps increase in interest rates would result in a mild loss on a portfolio of UK sovereign bonds for euro investors, but that loss would be partially mitigated by the currency reaction.