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Bank of England May Revise Quantitative Tightening Process amid Bond Market Sensitivity

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The Bank of England (BoE) may be the next central bank to face challenges in its attempt to unwind its balance sheet, as bond markets remain restless. Quantitative tightening (QT), the process of winding down bond purchases, has been underway for over a year at three major central banks, with hopes that it would occur quietly in the background as interest rates increased. However, longer-term borrowing rates have continued to rise as bond investors grapple with the implications of increasing government debt sales.

Last week, the European Central Bank (ECB) decided against accelerating its QT runoff, signaling the end of its rate tightening cycle. Speculation is now building about when the Federal Reserve will address the issue, as concerns grow about a potential crunch in bank reserves. Some strategists believe that the Bank of England will be the first of the three to make changes to its QT process in response to a steepening of its government bond yield curve.

Of particular concern for the Bank of England is the return of the “term premium” in US Treasury and other debt markets. The term premium refers to the risk premium demanded for holding long bonds to maturity instead of rolling short-dated paper. The Bank of England is actively selling securities from its stockpile rather than relying on maturing debt, which adds urgency to its balance sheet reduction efforts.

The Bank of England’s decision to unwind its balance sheet quickly is also costly for the UK Treasury. The Bank pays commercial banks its prevailing policy rate on additional reserves, which were credited at the Bank of England in exchange for bonds purchased during quantitative easing. As the central bank increases its balance sheet reduction pace, the expense to the UK Treasury mounts.

Although the Bank of England briefly halted its balance sheet unwind in September 2022 during a government budget crisis, it quickly resumed the process and even increased its projected pace in September 2022. However, as term premia have risen globally and there has been a sharp selloff in US Treasuries, long-dated UK gilt yields have soared, indicating a decline in bond prices. This increase in yields has occurred even as the Bank of England’s policy rates are seen to have reached their peak.

Bank of America analysts attribute part of the blame to a quirk in the Bank of England’s QT strategy that has forced it to sell more long-term bonds than originally planned. Bank of America suggests that the Bank of England may adjust its strategy and sell shorter-term bonds instead. The concern is that the Bank has been selling gilts from the same maturity buckets it originally purchased them from, even though the market value of some long gilts has dropped significantly since their purchase. The Bank of England’s balance sheet now includes more 1-3 year gilts than 20-year-plus tenors.

Deutsche Bank’s UK strategists also agree that the Bank of England may need to change its approach to QT. They suggest that the Bank could skew its gilt sales towards shorter maturities or sell evenly based on current market valuations. Either way, they highlight the importance of upcoming auctions to determine whether there is sufficient demand for the scale of sales that the Bank of England is currently making.

In conclusion, the Bank of England may be the next central bank to address challenges in its QT process as bond markets remain uneasy. While central banks hoped that unwinding their balance sheets would occur quietly in the background, rising borrowing rates and concerns about government debt sales have added complexity to the process. As the Bank of England faces a steepening of its government bond yield curve, analysts suggest that it may need to adjust its strategy for QT to mitigate potential market disruptions.

More detail via Reuters here… ( Image via Reuters )

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