Bank of England's Bond Market Challenges

The Bank of England (BoE) is facing an increasingly complex dilemma. After years of quantitative easing (QE) and purchasing vast quantities of government bonds, the central bank now finds itself in a precarious position as it begins quantitative tightening (QT) and the gradual disposal of those assets.

Recent market turbulence has highlighted the fragility of demand for long-dated UK government bonds, putting pressure on the Bank of England to reconsider its strategy. Forecasters predict the central bank may have to limit sales of its remaining £163 billion ($219 billion) of gilts with maturities over 20 years, or even halt disposals entirely. This would mark a significant shift in how it unwinds its crisis-era balance sheet.

The BoE's sale of its portfolio of government bonds, built up over a decade of quantitative easing programs, comes amid warnings that market volatility is increasing. This is attributed to the market, once dominated by stable buyers like pension funds, becoming increasingly reliant on less stable hedge funds and foreign investors.

Echoes of the Past: The 2022 Crisis

The sell-off of 30-year gilts earlier this month, triggered by rumors of the impending dismissal of the Chancellor, serves as a stark reminder of the events of 2022. Long-dated government bonds were at the heart of the market turmoil that ended Liz Truss's brief premiership.

Some analysts warn that the BoE, through quantitative tightening, is competing with a heavily indebted government for buyers, at a time when demand from fixed-income pension funds is waning. This situation may be exacerbating market volatility.

Policy Shift Proposals: What Experts Suggest

One voice advocating for a policy change is Michael Saunders, a former BoE rate-setter and senior advisor at Oxford Economics. Saunders suggests the Monetary Policy Committee (MPC) could announce that a large portion of its long-dated debt holdings will never be sold, under a new strategy.

Saunders argues that "the main effect would be to reduce the risk that the BoE’s QT program further destabilizes the gilt market."

The Bank of England is currently shrinking its bond holdings, which once approached £900 billion, at a rate of about £100 billion a year. This year, it plans to achieve this through £13 billion of active sales and allowing £87 billion of maturing debt to roll off naturally.

However, the volume of maturing gilts next year is lower, meaning that to maintain the £100 billion pace of balance sheet reduction, more sales would need to take place, potentially posing a market risk.

Investors surveyed by the central bank expect it to slow the pace of QT by £25 billion, implying only £26 billion of active sales. BoE Governor Andrew Bailey recently noted that “liquidity in the long end of the yield curve has changed, and that affects yields,” suggesting future sales volumes will be lower than previously anticipated.

Political Pressure and Financial Considerations

Quantitative tightening is causing tens of billions of pounds in interest and sale valuation losses for the Treasury, placing the Bank of England under increasing political pressure to shed debt from its balance sheet.

However, Saunders believes the MPC may take a cautious approach when deciding how quickly to proceed from October onwards.

The Bank of England is scheduled to provide its latest analysis at its August 7th meeting, with a decision due in September.

Details of Saunders' Proposed Plan

Saunders' plan would allow the bank to continue reducing its holdings of gilts with maturities between 3 and 20 years, totaling £290 billion, but it would retain the £163 billion of long-dated gilts, those with a remaining maturity of over 20 years.

Within the BoE's long-dated portfolio, about £120 billion would be written down to the £93 billion nominal issue price, crystallizing a £27 billion loss as a one-off increase in government debt. These assets would then be used to hedge the BoE’s corresponding £93 billion of currency liabilities, essentially the banknotes and coins in circulation.

According to Saunders, this arrangement would be profitable because cash is costless to the bank, while the average coupon yield on the nominal value of the long-dated gilts is around 2.7%. The bank could then make up the remaining £43 billion loss on the long-dated gilts while continuing to reduce the rest of its investment portfolio. Earlier, the Bank of Canada announced a very similar QT runoff arrangement.

Saunders argues that his proposal would have little, if any, fiscal impact on Reeves (the Chancellor), while the risk of market disruption would be significantly reduced.

The Bank of England bought more long-dated gilts under quantitative easing than other central banks after the financial crisis, Brexit and the pandemic. This means it has to actively sell debt, whereas other central banks can allow their balance sheets to shrink naturally.