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BoE: plagued by gilt

Criticism of the Bank of England is growing. Approval rates are now at a record independent-era low.

It’s a bit harsh. To their great credit, Bank officials have steered the UK through an inflationary shock driven by factors beyond their control and into an inflationary shock increasingly driven by factors within their control. They’re still not slaying, but at least it’s in their lane.

Wednesday’s consumer price index inflation reading and Thursday’s Monetary Policy Committee meeting are the crucial upcoming events.

Goldman Sachs has also chipped in today with a timely look at the Bank of England’s quantitate tightening framework, under which the Andrew Bailey bunch are reducing their pandemic-era stockpile through a combination of active selling and allowing mature gilts to roll off their portfolio.

When we wrote about QT back in the halcyon days of last September, Liz Truss had only been prime minister for three days (about 6 per cent of her time in office), but some systemic problems within the gilt market were already clear: the Bank was preparing to actively dump gilts at the same time the government was preparing for a huge wave of further issuance. Market gets flooded with supply, prices go down, simples.

The ‘fiscal event’ of late September led to a delay in active sales, but they’re now firmly under way, and the stock of gilts held through the Bank’s asset purchase facility is now £808bn per Goldman, down from £875bn last February. Chart from NatWest:

The Bank wants to get that number down to £325bn–£480bn, depending on conditions — but that’s looking like more and more of a challenge, reckon Goldman’s analysts:

Going forward, we think it is likely that the BoE will slow down the pace of active sales from October for three main reasons. First, net gilt supply to the private sector is poised to increase meaningfully over the upcoming years due to a combination of higher net gilt issuance and higher APF redemptions. Second, continued upside surprises in inflation and labour market prints have led to increased volatility and reduced liquidity in UK gilt market. Third, the repricing in gilt yields—if sustained—also implies higher debt interest costs and BoE losses, and thus higher gilt issuance.

They add that, like with just about everything, it’s very hard to make estimates currently:

But uncertainty around the extent of the slowdown in the pace of active sales is high. Our baseline is that the BoE will reduce the pace of active sales to around £7.5bn/qtr and keep the annual stock reduction target unchanged at £80bn next year. However, given that this pace is ultimately going to be determined by the BoE’s conversation with market participants and the latter’s willingness to digest gilt supply, we see the hurdle for the BoE to reduce the speed of active sales even further to somewhere around £5bn/qtr as low.

Currently gilt yields are primarily creating political pressure for the Government, but that could easily spill on to Threadneedle Street. The Bank has shown signs of being reactive to issues in the gilt markets already, with last Autumn offering an extremely early and extremely fire-y trial by fire.

Their record isn’t perfect, however. In a market where it’s tempting to look at curves and overall volumes while ignoring supply at specific tenors, Goldman says (our emphasis)

[While] market functioning is a key calibration criterion, the BoE has not been equally attuned to functioning issues in different segments of UK rates market. For instance, throughout last year, a scarcity of short-dated gilts led to a very wide front-end swap spread at the 2y point. Despite this, and the fact that the BoE itself had a stronger market footprint at the front-end of the curve, it announced in August that it would distribute sales evenly across all three maturity segments, and other than in Q4, has been doing so. Second, the MPC likely has a higher threshold than market participants to identify weakness in the gilt market. This was highlighted as recently as mid-May when MPC member Ramsden noted during a TSC hearing that there was a potential for the BoE to increase its annual target of stock reduction next year from £80bn currently, despite signs of poorer market absorption of gilt issuance.

Surveys suggest forecasters aren’t buying the Bank’s stated QT plans, seeing £70bn of stock reduction next year versus an £80bn target. Goldman says this “would imply a slowdown in active sales to around £5bn/qtr from £10bn/qtr currently”.

The timing of Goldman’s note is interesting as we’re likely on the verge of a step up in active sale plans. Here’s Imogen Bachra, from NatWest:

The BoE is slightly behind its run rate for the year if it wants to reach an £80bn reduction in its stock of gilts by September…

The BoE will publish the calendar for the next quarter’s QT operations on Friday at 4.30pm. This will be the last quarter of this year, when the BoE plans to reduce its total stock of gilts (in initial purchase proceeds terms) by £80bn. Maturing bonds (in July and September) will account for £35bn of that balance sheet shrink, and a total of £30bn (in initial purchase proceeds terms) has already been sold. Accounting for the last remaining auctions of this quarter, that implies sales in Q3 2023 of £15bn (in initial purchase proceeds terms). That would be the largest pace of quarterly sales since QT began.

Adding to the complexity, lower prices themselves make targets harder to hit, creating a difficult volume/value dynamic. As Bachra notes:

The more that gilt prices fall, the lower the total sales proceeds required from the BoE to meet a total of £15bn initial purchase proceeds. On the surface, this would imply less “supply” to the market. But the lower the sale price, the bigger the loss that the BoE realises and the bigger the hole that the Treasury has to plug.

If a slowdown does follow, the political consequences are potentially interesting. Reduced active QT should ease some pressure on rates, which would be positive news for Rishi Sunak, and should lower realised losses on Bank’s bond portfolio, thus reducing costs for the Treasury (which indemnifies the Bank against such losses).

Would a QT slowdown add up to much? Probably not enough to shift some very badly-positioned needles for both the Government and the Bank. Reading through to the precise effects QT has been having on monetary conditions seems impossible at the moment.

Still, if sales are slowed down without consequence, the Bank’s pointless contribution to pushing gilt rates over the past year or so may eventually be looked back on with some disapproval. But then again, punching oneself in the face has become the UK’s national economic pastime.

Read the full article here

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