Move over Quantitative Easing. Quantitative Tightening is the order of the day. Money printing is in reverse and balance sheet reduction — selling the government bonds bought during the QE era — is now a focus of the Bank of England.
Other central banks are treading gently. Selling bonds on this scale has never been done before. Nor has it been tried when markets have had to digest the ramifications of both high inflation and substantial rate hikes. Prices for bonds are today much lower (and yields higher) than when the central banks bought the same securities previously. So understandably, most central banks have been proceeding slowly.
But not the Bank of England.
Of all the central banks, the Bank of England has been the most aggressive in terms of selling the bonds bought during the QE era. The process itself involves the Bank both allowing existing bond holdings to mature, and selling its bond holdings into the market. This is not unusual. But what is unusual is the pace and scale involved.
Adjusting for the size of the market, in the UK the net effect is equivalent to sales of about 7.4% of all outstanding government debt. This is around 70% faster than the US Fed and well over twice the pace of the European Central Bank. That’s a huge amount of what is effectively new bond issuance that the gilt market has had to digest.
For investors this could be an opportunity. Inflation has already started to fall and further reductions are likely over the next six months, reflecting falls in commodity prices. This decline is already visible in other data, with manufacturing input prices having come down from a peak of more than 25% to the current level of -3%. This will take the pressure off the Monetary Policy Committee to hike rates much further, and potentially allow for rate cuts in 8-12 months’ time, which are not expected by the market. As a result, I predict that today’s 10-year bond yields of 4.5% will look cheap in the near future.
The Treasury can’t be happy. The Bank of England’s own numbers show eye-popping value destruction from the QE experiment. Latest official estimates suggest, over its lifetime, that QE is likely to cost the state a net £110 billion, around 5% of GDP.
It doesn’t have to be this way. The Bank’s fast pace of gilt sales is a choice that pushes down on prices, worsening those losses the taxpayer has to make good. And it is a choice that crystalises the losses at today’s low bond prices, rather than going slow and waiting for interest rates to go back down when prices would be better. It is a choice that also pushes up borrowing costs for the Government, by our estimate to the tune of 0.4% compared with the gentler pace of the Fed.
Last week Bank of England Governor, Andrew Bailey, told Parliament interest rates were at the top of the cycle. So why then is he so keen to sell the gilts now, at the worst possible time? Perhaps the Monetary Policy Committee should remember their secondary objective, after controlling inflation, is to support the wider prosperity of the UK. Not making avoidable losses is part of that.
Instead, armed with an indemnity from the Treasury, craftily negotiated by the Bank when Alistair Darling was Chancellor, the Bank of England is rebuffing questions on the topic. In the worldview of Threadneedle Street, the QE losses are not their problem. Deputy Governor Ramsden has explicitly stated profits or losses aren’t a factor in their decision making.
The reputation of the UK central bank took a beating when the UK infamously sold its gold holding at the bottom of the market in the early 2000’s. The way the Bank went about implementing that decision left much to be desired. Sadly, there are many parallels with the way the Bank is operating today.
For example, similar preannouncements of sales are used, depressing prices. Similar disinterest is expressed by the BoE in the prices achieved and or scale of losses crystalised. And ahead of this week’s MPC meeting, similar fears exist in the market that the pace of sales might even increase.
If history rhymes with the past, the actions of the Bank of England could again mark the bottom of the bond market. For investors, with inflation now coming down and peak rates in sight, this could be an opportunity. Lock in the high gilt yields while you can.
Christopher Mahon is Head of Dynamic Real Return, Multi-Asset at Columbia Threadneedle Investments