MIKE DOLAN: The drying-paint drama of subtle quantitative tightening
Some think the Bank of England may be the latest to paper over the QT cracks
London — Much as central banks want to convince markets that unwinding bloated balance sheets is about as riveting as watching paint dry, restive bond markets show there may be more drama and sensitivity than they’d like to let on.
And some banks think the Bank of England (BOE) may be the latest to paper over the quantitative tightening (QT) cracks as soon as this week.
QT, a reversal of mostly pandemic-related bond buying, has been under way at three of the major central banks for more than a year — quietly in the background, they hoped, as official interest rates shot higher.
But even as policy rates crest, longer-term borrowing rates have continued to spiral higher as bond investors digest the implications of rising government debt sales while central banks pull out of the market in slow, steady fashion.
Already, there’s been some awkward shuffling of feet around a process that was meant to be just balance sheet plumbing.
Despite many expectations to the contrary, the European Central Bank last week declined to up the pace of its QT runoff — deciding instead to give the whole issue a bodyswerve for now as it signalled the end of its steep rate tightening cycle.
The Federal Reserve may be further away from dealing with the QT issue head on. But already speculation has been building about just how long it can continue to back away from such edgy treasury markets for fear of a crunch in bank reserves.
Some strategists think the BOE will this week be the first of the three to flag a rejig of its QT process due to a worrying steepening of its government bond yield curve even as the economy skirts recession and BOE rates top out.
With a return of the long-absent “term premium” in US treasury and other debt markets — essentially risk premia demanded for holding long bonds to maturity as opposed to rolling short-dated paper — QT comes high on a list of suspects.
That’s especially so for the BOE, which has been actively selling securities from its stockpile rather than relying on maturing debt to just roll off organically — as the others do.
London’s haste to reduce the BOE balance sheet is all the more urgent given the Bank, unusually, pays commercial banks its prevailing policy rate — now at 15-year highs of 5.25% — on added reserves the banks were credited at the BOE in return for bonds originally bought via “quantitative easing [QE]”.
The ultimate expense to the UK treasury is mounting as a result.
Though the BOE was forced to briefly reverse its balance sheet unwind during the government budget farce and pensions shock of September 2022, it resumed QT quickly and even upped its forecast pace as recently as this September to about £100bn over the year ahead from £80bn previously.
But as term premia have climbed around the world and a sharp sell-off in US treasuries spilt over into other sovereign debt markets, long-dated UK gilt yields have soared anew even though BOE policy rates are now seen to have peaked.
Since the decision to up QT, 30-year gilt yields added another 50 basis points to 24-year highs at 5.21% last week and 10-year yields jumped by as much as 50 basis points. The long-end spike went as far as steepening the UK’s two- to 30-year yield curve back into positive territory for the first time since May even as evidence of UK economic slowdown mounted.
Alongside overspill from treasuries, Bank of America (BofA) puts at least part of the blame on a quirk in the BOE’s QT strategy that has forced it to sell more than twice the amount of long-term paper than originally planned — and which may force it to rethink what maturities it sells.
In what it calls “QT bucket tweaks”, the BofA strategists believe the BOE may this week trail the case for a skew shorter in “active” gilt sales before a formal announcement in December.
The nub of the problem is that the BOE has been selling gilts in equal amounts from the same three- to seven-year, seven- to 20-year and 20-year-plus maturity buckets in which it bought them originally.
But the BofA team point out that total sales of each targeted bucket reflects purchase prices during QE even though the price of some long gilts have more than halved on the open market since the BOE purchased them.
The 30-year gilt due in 2051, for example, is trading as low as 44p to the pound.
“The Bank is therefore doing far more QT at the long end because it is selling those gilts at less than half their cost,” they told clients. “This means that the Bank is selling a disproportionately large share of longs.”
Reinforcing the point, the team point out the market value of the one- to three-year gilts at the BOE is, at £172bn, now more than the total £99bn of 20-year-plus tenors.
The BOE in September tagged on a line to its standard QT wording to reflect this concern, adding that it will “continue to monitor whether the current approach of selling gilts evenly across short, medium and long maturity sectors in sales proceeds terms remains appropriate”.
“Current conditions at the long end of the market make it harder for the Bank to continue to argue that QT is operating ‘in the background’”, BofA said.
Deutsche Bank’s UK strategists agree and think “the bar for a shift in QT policy is lower heading into year-end”.
Deutsche argues the BOE could either skew gilt sales shorter or agree to sell evenly based on current market valuations.
Either way, it added: “We will be closely watching upcoming auctions to gauge whether there is sufficient demand for the scale of sales now being pushed through by the BOE.”
A bit more exciting than watching paint dry.
• The opinions expressed here are those of the author, a columnist for Reuters.
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