The Bank of England’s £ 28bn problem


When the Bank of England presented its plans in August to unwind its £ 875 billion bond purchase program, it pledged the process would be “gradual and predictable”. But the central bank’s sudden shift to higher interest rates has raised the prospect that the so-called “quantitative tightening” could start off with a bang.

Just a month ago, the BoE was expected to stay put at least until March of next year, with most investors betting the first rate hike wouldn’t come until the summer. After a series of warnings about high inflation from Andrew Bailey and his colleagues, a take-off is expected next month, with a second increase to follow in December or February.

Importantly, it would take the BoE’s interest rate to 0.5%, the level at which it plans to begin the process of canceling quantitative easing by halting reinvestments of maturing bonds it holds. As it turns out, the £ 28bn worth of BoE-held bonds mature on March 7 – the largest reinvestment since Threadneedle Street started buying the bonds.

Investors are wondering if much of the demand – which they until recently took for granted – is about to evaporate. The figure is large enough to trigger major market moves, analysts said.

“They are neither predictable nor progressive, they create massive binary risk,” said John Wraith, head of UK rate strategy at UBS.

Of course, the markets were still going to have to deal with the BoE’s exit. But a criticism of the central bank’s plan to reduce the size of its balance sheet by stopping reinvestment – that bond repayments are by nature “lump sum” – has been compounded by the BoE’s abrupt change in schedule.

Investors had so far assumed that quantitative tightening would start during a relative lull in bond redemptions: only £ 9bn of bonds in the BoE’s portfolio are expected to mature within 18 months of the March redemption.

For Bailey, the ability to shrink his £ 28bn balance sheet in one fell swoop may be part of the lure of past rate moves. Over the past year, the Governor of the Bank of England has repeatedly asserted that reducing his holdings of gilts would free up margin to “go big and go fast” with another round of quantitative easing to time for the next crisis.

The timing of the March repayment “must make it tempting to advance the hikes by just a few months, especially since the governor has spoken of the need for a relaxation of QE since 2020,” wrote the Citi rate strategist , Jamie Searle, in a recent note to clients.

The problem is the additional uncertainty that is injected into the markets at a time when investors are already starting to question the wisdom of the BoE’s plans. Bailey’s unexpected comments on Sunday that the BoE “will have to act” to curb inflationary pressures rocked interest rate markets Monday morning, triggering a massive selloff in short-term gilts.

Meanwhile, a more subdued response in longer-term debt and the failure of the pound to profit much from the prospect of rising borrowing costs are a sign of growing markets concern over what A rapid rise in interest rates is a “policy error” that could quickly end up being reversed.

As markets quickly turned to price in an aggressive tightening path for the BoE, many investors and economists argue that higher interest rates risk stifling the UK’s economic recovery and will not succeed. much to tackle an inflationary surge that is largely the result of supply bottlenecks and a global surge in energy prices.

The repercussions of the BoE’s hawkish turn have been felt outside the UK. The bank’s September meeting, when it first raised the possibility of a rate hike in 2021, helped spark a global bond sell-off amid speculation the Federal Reserve might also opt for earlier tightening.

Markets may have priced interest rates to return to 0.5% before March, but they have barely begun to grapple with the consequences of ending QE reinvestments, according to Theo Chapsalis, chief strategy officer. UK rate of NatWest. Once they do, even larger market swings could occur, the decision to raise rates will likely be worth “20 basis points up or down” for the gilts market, he says. .

Whatever the outcome, the BoE’s £ 28bn puzzle underscores that the oil tanker’s QE turnaround process is likely never to go smoothly.

“There are already a lot of people in the markets bamboozled by the BoE’s handbrake,” says Wraith. “But putting the March buyback on the line makes the stakes so much higher. Central bankers never like to surprise markets, but somehow it’s going to be a big surprise. “

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