Poor Andrew Bailey, nothing is ever simple.
The Bank of England’s monetary policy committee is expected to approve active bond selling at its meeting next week, completing a long process of first saying they want to do it, then saying they will be do it and now doing it.
This process of quantitative tightening (the unwinding of quantitative easing) effectively began in the spring when some maturing gilts were allowed to come off the books of Threadneedle Street without the principal being reinvested. Active selling is the second most complicated part of this monetary escalation.
Here is Brian Hilliard from Societe Generale, with our emphasis:
We have already admitted in previous comments that we were puzzled that the committee did not make a decision on gilt sales at the August meeting, after being briefed by Bank staff on a possible strategy sale at that time. Instead, the August minutes confirmed that, as per the plans announced in May, the vote on this would take place at the September meeting, although it is obvious that the matter was discussed at the last meeting. Why the delay?
Especially since the MPC currently tends to increase the quantum of tightening, if economic conditions warrant it, we think the committee will be keen to use the additional tool of quantitative tightening, even though we think it will have far less power, pound for pound, than quantitative easing.
Ben Bernanke’s well-worn joke about QE was that it works in practice, but not in theory. It’s disputed, but even then things seem pretty clear compared to QT. While the Fed let its balance sheet shrink to the point of turbulence in US funding markets, it did so by letting its bond holdings mature. A major central bank has never attempted to sell bonds to reduce its balance sheet.
The Bank is about to take a big step into the unknown, and the timing could hardly be worse.
First, the British gilts were slaughtered. Here is Reuters, as of Tuesday:
Bond markets welcomed the arrival of Liz Truss as Britain’s new Prime Minister with the biggest sell-off of long-term British government debt since the COVID-19 pandemic caused turmoil in global financial markets in March 2020 .
Yields on 30-year gilts – which are sensitive to rising emissions and long-term inflation – rose almost 25 basis points at one point and at 1515 GMT they were 17 points basis to 3.374%, on course for their biggest daily jump since March 2020.
The damage to 30-year yields, in graphical form:
Second, Truss – after a long summer of tussling with conservative competitors – now faces the worst cost-of-living crisis in roughly half a century. According to the Financial Times:
Within minutes of entering Number 10, Truss set out to form a cabinet and finalize an energy relief package that will set the tone for his premiership and sharply increase government borrowing.
Truss allies have suggested the household package will cost £90bn, with an estimate of £40-60bn for the commercial element, which is still being finalised, over two years.
So around £150billion, which according to careful monitoring of the UK government’s recent crisis spending, is the equivalent of just over two furlough schemes.
There’s more than one way to skin a cat, and “Trussonomics” seems – despite the protestations of its namesake – to have evolved to include windfall taxes. But it seems almost certain that, one way or another, the government will have to borrow to cover these costs. This means gold sales. Batches gold sales.
This is bad news for the BoE, which could find itself selling snow during a blizzard. Here is ING with a nice number quote and some graphics:
From the gilts’ perspective, any additional debt issuance would come on top of the projected deficit, the cost of any additional tax cuts, and the additional amount of debt handed over to private investors by the BoE through quantitative tightening. (QT). The cost of the energy package is still subject to many uncertainties, but assuming £110bn (£70bn for households and £40bn for businesses) split evenly between this financial year and next, private investors will be asked to increase their exposure to gilts by a record amount: around 120 billion pounds this year and 210 billion pounds next.
Suffice it to say that the preference of the gilts market is to finance the energy package through other forms of financing.
Of course, the appetite for gilts should not be underestimated, adds ING:
At the start of the 2020-21 financial year, the Debt Management Office planned to issue £156bn worth of gilts, it ended up selling £486bn. However, the more relevant metric here is the increase in private investors’ net exposure to gilts, which rose by just £107bn that year, from £117bn and £210bn. sterling this year and next year according to our forecasts.
And the appetite seems healthy now:
In case anyone is worried, the UK has no problem borrowing money from the capital markets right now.
I just raised £3.5 billion in 3-year gilts at 3.2%.
The coverage ratio (this is important – it’s how many bids there were for each bond) quite healthy at 2.6 times. pic.twitter.com/gwXqh0A1uN
— Ed Conway (@EdConwaySky) September 6, 2022
But the danger of oversupply seems pretty clear. The Bank has tacitly acknowledged this, saying in a notice last week that it would try to avoid clashes with the UK’s debt management office and would not accept bond buyers.
take the piss bargain hunting:
The Bank will closely monitor the impact of its gilt sales program on market conditions and reserves the right to change its timing (including gilts for sale), pricing methodology or any other aspect of its approach at its sole discretion.
The Bank reserves the right to reject offers, in whole or in part, including in light of other offers received, at its sole discretion.
This should save face for the Old Lady, but it means QT could start with a whimper rather than a thump.
Bailey, speaking to MPs yesterday, acknowledged that things might have to get a little off the cuff:
We have maintained very open lines with the Treasury and the Office of Debt Management, which I think is particularly appropriate from an operational and market perspective. Our team is following this very closely.
Antoine Bouvet, ING’s senior rates strategist, says there’s “absolutely a chance” QT may not launch as expected, telling Alphaville the chance of such an outcome is around 10% at 20%.
If he fails, Bailey might find it a bit more difficult to reload his monetary bazooka. So, no more rate hikes?
Who will buy Bailey’s bonds?