Historic shift to auctioning short-dated securities

LONDON: The Bank of England (BoE) is set to become the first major central bank to sell off assets built up during a 13-year-old stimulus package, becoming a test for how quickly markets can pull away from easy money policies.

The UK central bank, which was buying gilts just weeks ago to ease market tensions, is planning an auction of the first £750 million ($864.23 billion or 4.09 RM billion) of short-dated securities it wishes to offload.

The move aims to reverse the quantitative easing program that helped support the economy during the global financial crisis and the pandemic.

Under the program, the BoE bought bonds in financial markets to push interest rates near zero, hoping the easier money would give investors confidence and help spur growth.

While quantitative easing has limited market interest rates, Governor Andrew Bailey hopes that its reverse, called quantitative tightening (QT), can work in the background and leave the focus on the benchmark lending rate. of the BoE as the main tool for managing monetary policy.

“Tightening monetary policy through the interest rate channel has a proven track record,” said Paul Hollingsworth, chief economist for Europe at BNP Paribas.

“With QT, central banks are entering uncharted waters, the risks of unintended consequences are clearly higher.”

Yesterday’s auction marks another important step towards bringing BoE policy closer to the parameters that prevailed before the shock of 2008-2009, although Bailey says the balance sheet will not shrink to its size before the financial crisis.

The governor and his colleagues are alarmed that inflation has jumped to 10.1%, its highest level in 40 years, more than five times their 2% target. They have raised the BoE’s key rate seven times since December and are expected to register the largest increase in 33 years tomorrow.

This would take the key rate to 3%, its highest since the end of 2008, just before the start of the quantitative easing programme.

The central bank began to cut its asset purchase facility in February when it agreed to allow maturing bonds held in the fund to roll off the balance sheet instead of being replaced.

While the US Federal Reserve and the European Central Bank also have quantitative easing programs, neither has started active selling yet.

“We expect the BoE to proceed cautiously,” said Daniela Russell, head of UK rates strategy at HSBC. “It could therefore support a less pronounced rate of tightening from here and therefore give further bullish momentum to gilts.”

Allowing the auction to take place is a sign of confidence that the markets are calm enough to absorb the additional obligations. Bailey has always said that sales could be interrupted in turbulent times. Yesterday’s start was postponed from Oct. 3 to allow the market to shake off the turmoil of a few weeks ago in a squeeze on longer-dated bonds that are excluded from BoE sales for now.

Investors had dumped gilts and sterling after then-Prime Minister Liz Truss implemented a program of deep tax cuts funded by additional borrowing. This episode contributed to Truss’s decision to step down and hand over power to Rishi Sunak, who quickly canceled the plan.

The sales come at a delicate time for the Treasury and the BoE. Investors are already being urged to absorb record Debt Management Office (DMO) issuance and the rapidly growing deficit.

On current trends, the government budget deficit for 2022-23 as a whole could hit £170bn (RM976.7bn), nearly double the £99bn (RM539bn) forecast. by the Office for Budget Responsibility in March.

The BoE also sells bonds at prices below those at which they were purchased, forcing it to realize losses.

It passes that responsibility on to the Treasury, which this exercise is expected to transfer more than £11 billion (RM59.9 billion) to the BoE to cover expected losses.

“The start of active selling this week should draw investors’ attention to the potential costs of QT, which ultimately adds to the already strong cash supply numbers,” said Imogen Bachra, head of the UK rates strategy at NatWest Markets, which forecasts 10-year yields. rising to 4.3% against about 3.5% currently.

“Markets should not overestimate the impact of shifts in fiscal policy on the supply outlook.”

For Bailey, the reduction in the size of the BoE’s balance sheet is part of an effort to prepare for another possible crisis.

In a June 2020 Bloomberg Opinion article, he said that the central bank’s excessive reserves “could limit room for maneuver in future emergencies” and concluded that “it may be best to first consider adjusting the level of reserves without waiting to raise interest rates on a sustained basis.

The BoE coordinates with the government which bonds to sell and when. A gilt maturing in 2029 is excluded from yesterday’s sale because it was recently auctioned by the DMO.

DMO chief executive Robert Stheeman acknowledged that BoE selling will contribute to greater market volatility.

“While the impact on confidence and growth expectations from the Chancellor’s fiscal pullback warrants some lowering of long-term yield expectations, we believe it is overdone with uncertain final demand,” said Howard Cunningham, portfolio manager at Newton Investment Management.

He cites the DMO’s record supply forecast once BoE selling is factored in as the reason for his short position in gilts.

One question the BoE has left unanswered is how it will dispose of the long, inflation-linked gilts it recently purchased as part of its temporary operation to stabilize financial conditions.

These are held in a separate portfolio from the main central bank gilt facility.

The BoE said on Oct. 20 that it would outline its approach to unwinding its most recent purchases “separately in due course.”

“It is only after the bank reduces its holdings of its temporary program that we believe it will start selling long gilts of its holdings in the asset purchase facility,” said Megum Muhic, analyst at RBC Capital Markets.

“We don’t see the BoE wanting to add unnecessarily to the net long supply coming next year and increase the risks of a repeat of the pension guarantee crisis of a few weeks ago.” —Bloomberg

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