Janet Wilkinson
Hello and welcome to our Partner Of Choice podcast, where we combine insights from the RBC Capital Markets team on credit, rates, and FX to deliver leading solutions across issuance and trading. I'm your host, Janet Wilkinson, Managing Director and Head of Global Markets Flow Sales, EMEA. And today I'm delighted to be joined by Kofi Oteng who heads up Flow Rate Sales and Ben Toms, our Equity Research Analyst here at RBC.
Ben Toms
Thanks, Janet, glad to be here.
Kofi Oteng
Thank you for having me.
Janet Wilkinson
Super. I'm very excited to talk to you both about the outlook for UK interest rates, a very hotly debated topic in the market, something all of us take home every day in the UK that not only touches us personally, but also touches all of our clients and our partners. Kofi, let's start with the big picture. What's driving the current uncertainty and complexity around UK interest rates, and what does this mean for our UK banking institutions?
Kofi Oteng
There are three topics that come to mind when I think about the complexity and uncertainty of the interest rate environment in the UK. You've got the economic backdrop in the UK, the path of rates implied by the Bank of England, and the broader geopolitical landscape. If I touch on the economic backdrop, just this week, we had labor market data and inflation data, both of which painted a pretty mixed picture of the UK. On the inflation numbers specifically, headline CPI inflation overshot both the Bloomberg consensus and the Bank of England projections, but against that services inflation undershot both the bank's projection and the consensus. Now the Bank of England's Monetary Policy Committee have indicated that they want to look through what they see as a spike in inflation in the coming months, and the recent data hasn't changed my personal view or the House view that the Bank of England will remain on a steady quarterly cutting cycle. On the tariff side, we did see some pretty significant moves across markets on the initial announcement of the tariffs, although I actually feel now that we're starting to see signs of tariff fatigue in the market. We've seen normalization of some of the initial moves on the currency space, similar in rate markets and equity markets have continued to rally.
For the UK specifically, now that the UK is outside of the EU, its reaction to US tariffs is already starting to diverge from that of the EU. It's worth noting that, in particular, the UK's trade with the US is skewed towards services. Goods account for only around 1/3 of total UK exports to the US, which is worth around 1% of GDP and trading goods is usually where the tariffs land. When thinking about tariffs from a global rate standpoint, the main focus is going to be how central banks respond to the threat of these tariffs, and the form the tariffs actually take, and my personal view is that central banks will wait and see what the tariffs look like, how long they may be in place for before deciding on how to respond with adjustments to monetary policy.
Janet Wilkinson
Ben, as an equity banks analyst, you're so close to what these interest rate complexities mean for our banking partners. So is this uncertainty becoming the new norm? And how do you feel the UK banking institutions are adapting to these conditions and the ongoing uncertainty. Are they pivoting? What changes are they making? What are they doing, and what's your view?
Ben Toms
Good question. So maybe it's useful to start off with to provide a little bit of context. European banks, they're up about 20% year to date. That's outperforming the sector by about 10%. That makes it the fifth best relative start to the year since 1990. Now we had similar starts in 2022 and 2023 but both of those were quickly unwound. Now, in our view, performance in Europe this year has been driven by three factors. A bear steepening curve, and banks like bear steepening curves, political risk subsiding, we had peak risk in December, and a stable macro environment. Now, if we zoom into the UK, we also have another factor, and that's softer regulation. UK rates, they're expected to come down just below 4% by the end of 2025 but, expectations have been moving all over the place, and to be honest, rate volatility seems to have been a little bit of a theme over the last three years. In Q1, that volatility has seen banks pause their debt issuance plans. But this is a supply problem, in our view, not a demand problem, and issuance should pick up again later in the year. Now, lower rate generally means lower margin, but banks have various tools to deal with that pressure. Firstly, they have the infamous structural hedge. This is a book of interest rate swaps that take away from the P&L as rates go up, that give back as rates come back down. Secondly, UK banks have been leaning into risk, which has been benefiting their net interest margins. For example, they've been lending higher up the risk curve in mortgages. Mortgage volumes will also be supportive with lower rates meaning that customers are going back out and buying houses, and we expect volumes to be modestly up in 2025. Banks have also been building their non-interest income line, but that's pretty tough to do when there's a subdued GDP environment. They're also potentially take some inorganic actions. We had four major transactions in the UK in 2024. We expect that trend to continue, although the targets this year are probably more likely to be in the Wealth space. If you have top line pressure, another way you can deal with this as a bank, is to cut cost. Now, 50% of banks cost bases are people, so that means restructuring, and that restructuring will probably be supported by digital developments and artificial intelligence. So to sum up, whilst lower rates will create top line pressure for UK banks, once you consider all of the moving parts in the P&L, rates in the two to 4% range with a slightly upward slanting curve, could actually be considered a sweet spot for the UK banks.
Janet Wilkinson
Thanks for that, Ben, you always have the amazing ability to take something that is so complex and simplify it and make it sound so easy. So we've covered European banks and their huge rally and outperformance. We've looked at the UK banking sector as well. But what about the regulatory landscape? Let's turn our focus to that and how the regulatory changes are affecting the UK banks and whether, and how, they can stimulate growth and innovation. So Kofi turning over to you, what are your thoughts about the regulatory impact on UK banks and the go forward?
Kofi Oteng
One of the themes that's been particularly topical over recent months when we think about banking regulation, with Trump now in office, in the US, is this narrative around deregulation of the banking sector. From a regulatory standpoint, the potential changes to the supplementary leverage ratio could be significant. The SLR is a ratio that measures a bank's tier one capital to its total leverage exposure and was a key part of the Basel III reforms that were introduced back in 2014. An adjustment to the SLR could be extremely supportive for fixed income assets, although it's worth bearing in mind that the last time an SLR exemption was delivered was back in March 2020 in the midst of illiquidity crisis caused by the COVID 19 pandemic.
Janet Wilkinson
Thanks, Kofi. And Ben, moving on to your view from an analyst perspective, maybe you could touch a little bit on regulation and the changing landscape and possibly how this is stimulating growth, or maybe not.
Ben Toms
Well, it's probably useful to provide some context again, start off with. We've had 15 years of increasing regulation in Europe, which have generally meant higher capital levels for banks. We've also had an environment where governments have used high banking profits to increase taxes, and Spain is example of that. And to be honest, in the UK, going into the last election, there was a discussion around deposit tiering, which is essentially a tax on banks. But two things have changed. We have a new president in the US. He's pushing lower regulation on banks, and that's having a drip feeding effect into Europe. And in the UK, we have a UK government with a growth agenda, and there's been a big step change in the way they think about regulation. If I just give you some examples. So for example, we've had the removal of the head of the Competition Commission, and we've already seen a block deal that's being revived. We've had a delay of Basel, that's been pushed to 2027. The Bank of England, they've changed mortgage LTV limits that allow banks to lend more and higher up the LTV spectrum. We've also had the unthinkable, where governments have turned and been supportive of banks in relation to motor finance litigation. We've also had proposals for a change in the rules around defined benefit pension services, which banks have some of the largest defined benefit schemes in the UK. Now, if we look forward, there's a good chance that Basel could get softened. We also think potentially, if you get a reduction in the MREL threshold to take some of the smaller banks outside of the scheme. We'd also like to see a change in the ring fencing rules, which currently benefit foreign entrants, allowing banks in the UK to use the first 35 billion of their retail deposits to fund other parts of the bank. Net effect of all the above is that we have probably the best regulatory environment for UK banks post the financial crisis.
Janet Wilkinson
That's certainly positive as a takeaway, Ben, thank you. Now our clients are at the heart of everything that we do. And with all of this uncertainty, Kofi and Ben, how are we supporting our clients through all this uncertainty, both with thought leadership as well as liquidity facilitation. Ben, maybe I could pass to you on the thought leadership piece and how we are doing our best to partner with our clients through these challenging times.
Ben Toms
Well, net interest margin is always a core theme for UK bank investors. So in April 2024 we launched a product called The Vault, developed it with RBC Elements, they're our in-house data science team. The Vault tracks daily and in real time, more than 10,000 residential buy to let mortgage and deposit products, and that's across more than 75 banks operating in the UK. If you add that all together, it's more than a million data points per week. We've made that data available to our clients through an online application, and that includes the functionality to look at data on a bank-by-bank basis, or a product-by-product process. So The Vault provides investors with insights on the development of bank profitability in advance of results. And from Kofi’s perspective, his clients find it useful to know how peers are pricing mortgages.
Janet Wilkinson
Kofi, moving on to you. How are we supporting our clients with liquidity provision through these times of volatility, and also making sure we stay close to them as a partner through these times?
Kofi Oteng
I think to echo the point that Ben made earlier, one of the strengths of RBC is our collaborative approach and our OneRBC focus when it comes to our clients. And the work that Ben and the team have done specifically around mortgages provided by banks, has been incredibly useful for a number of our clients on the institutional side of the business. If you think that the UK mortgage rates are effectively priced off the sterling interest rate swap curve. We have a number of clients that express views in sterling rates via the swap curve, and activity from mortgage hedges and new housing activities a huge driver of that swap curve. So we've had some really great success in connecting with Ben and his broader team on providing some of that content into our clients to help them arrive at the most appropriate investment decisions for them. RBC has a long standing history of supporting our clients through times of market stress and turbulence, when I think back to the financial crisis, to the COVID 19 pandemic, RBC stood by our institutional partners and helped them navigate some really turbulent times. Now we have an extremely collaborative culture, and I think that really sets us apart. One of the hallmarks of our success over recent years has been our ability to provide liquidity across rates, FX, credit, and a number of other asset classes to help deliver positive outcomes for our clients in times of market stress.
Janet Wilkinson
As we look to wrap up this podcast, what is the one thing you both feel our clients should stay alert to, whether it's an obstacle to avoid, or an opportunity to grasp. Ben, maybe you could kick off with your thoughts on this.
Ben Toms
So our view is that the opportunity in UK banks really comes from stability. All in, the profits for UK banks in 2025 should be relatively flattish to 2024 and you might get a bit of EPS accretion through buyback schemes. Now, stable earnings should give you a high degree of confidence in UK bank distributions. So not only are UK and European bank dividend yields attractive relative to other sectors, they should also be relatively sustainable, which means that we could finally see UK bank cost of equities moving back towards the 10% level, which should continue to be additive to bank valuations. Now the big thing to look out for, this year for us in the UK, is motor finance litigation. We have a supreme court hearing in April with a judgment likely before half one results, the wrong outcome from this event could end up costing the sector billions in litigation costs.
Janet Wilkinson
Kofi, moving on to you, what are your thoughts on the opportunity or the obstacle?
Kofi Oteng
I'd probably say there are two things to watch out for. One, the normalization of global interest rates. We've come from a point now where elevated inflation has driven central banks to push interest rates to higher levels, and those are still currently being sustained. I think as we start to see some policy normalization that could create a number of opportunities for investors in the rate space. The second point is more something to be cautious of, and that's just the evolving situation in the US in terms of tariffs and the geopolitical landscape. You know, we do have this Trump wild card that's in place for markets at the moment, and I think it's just something that investors need to be mindful of, especially given that a well held, well thought out macro view can quite easily be disturbed by a headline or a comment that comes out of the US.
Janet Wilkinson
So thank you, Kofi and Ben, for your valuable insights today on what is a very important and topical discussion. And thank you to all of you for listening to Partner Of Choice, an RBC Capital Markets podcast recorded on the 19th of February 2025. And if you enjoyed this episode, please share it with your colleagues and peers.