Bank of England interest rate decision: gilts are the hot topic

  • The BOE plans to raise the Bank Rate for the second time to 0.5%.
  • Consumer prices rose 5.4% in December, nearly a 30-year high.
  • The passive roll-off of the gilt portfolio should start in March.
  • Markets and the British Pound priced in higher rates and lower bonds.

The Bank of England is expected to announce its second pandemic first when it details its plans to reduce its 895 billion pound ($1.2 trillion) balance sheet.

In December, the bank became the first to withdraw its COVID housing by raising its base rate from 0.1% to 0.25%. Another increase to 0.5% is widely expected for Thursday’s Bank of England (BoE) monetary policy meeting. This is the pace at which the bank has announced that it will begin to unwind its portfolio acquired over the past decade. The base rate was 0.75% in January 2020. This would be the first consecutive rate hikes since 2004.

BoE discount rate

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The BoE holds more than half of the total issuance of standard non-inflation-linked gilts, £875bn and around £20bn of corporate debt, bought in a bid to keep commercial interest rates low.

This massive flood of cash into the UK economy, coupled with almost two years of effective zero interest rates – from March 2020 to December 2021 the base rate was 0.1% – complicated by soaring energy costs , supply chain restrictions and strong consumer demand, produced the most rapid acceleration in domestic inflation on record.

BoE balance sheet

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Since the BoE’s own efforts are at least partly responsible for the tremendous price spike, bankers are eager to show that they have monetary policy under control and are capable of containing inflation.

Inflation

The consumer price index (CPI) in the United Kingdom has increased sevenfold in one year, rising from 0.7% in January to 5.4% in December. Core prices rose three times, from 1.4% to 4.2%.

CPI

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As in the United States, another economy plagued by a meteoric rise in inflation, it is the speed of earnings as much if not more than the real rate that has pissed off consumers and central bankers so much. America’s headline CPI in December was even higher at 7% from 1.4% at the start of the year.

Producer prices have soared even faster than retail prices, indicating that manufacturers are absorbing some of the increases and that these pressures have not run their course.

The UK Producer Price Index (PPI) on the input or cost side was 13.5% higher for the year in December. It jumped 1.9% in January. Producer prices rose from 0.2% in January to 9.3% in December.

DPI input

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Quantitative easing and tightening

The term quantitative easing (QE) was coined by German economist Richard Werner, while working at the Bank of Japan in 1995, to describe the purchase of government bonds as a means of overcoming limits of the central bank’s standard interest rate policy.

During the financial crisis of 2007-2008, quantitative easing was used by the United States, the United Kingdom and the euro zone to bring economic interest rates below their nominal base rates which were already at or close to zero.

Before the US Federal Reserve began its first round of bond acquisitions in late 2008, the central bank held between $700 billion and $800 billion in Treasuries on its balance sheet. By the end of the three rounds of QE in 2013, the Fed’s portfolio had swelled to over $4 trillion. In the two years of the pandemic, that amount doubled to nearly $9 trillion.

Quantitative tightening (QT) is the reverse of easing. Instead of buying bonds, the bank lets the bonds mature and does not reinvest the proceeds in new debt, thereby reducing its holdings, or it actively sells bonds in the credit market. Either way, the liquidity of the financial system is reduced, which ostensibly causes higher interest rates.

BEP QT

The BOE’s rate target of 0.5% for a passive QT or roll-off is expected to be met on Thursday and Governor Andrew Bailey is expected to discuss the bank’s balance sheet reduction plans.

A passive process could begin in March when the 2022 4% gilt matures. The bank holds 25 billion of this note. An outright reduction in the bond portfolio would drop holdings to around £435bn by 2031, which would be roughly equal to banks’ pre-pandemic holdings

Last August, the BOE said it would actively sell gilts until the “discount rate reaches at least 1%” and “depending on prevailing economic circumstances.”

The BoE has given little indication of how big it wants its balance sheet to be, except that it will be “significantly larger” than before the 2008 crisis, and well below its current level. .

Results and risk

Many, but not all, economists believe that interest rates on government debt will rise and the yield curve will steepen as the availability of bonds increases. This, in turn, should also drive up commercial interest rates.

It is also possible that a risk-averse financial system, having suffered two major crises in just over a decade, may be able to absorb debt without major changes in interest rates.

No central bank has attempted a prolonged reduction in its balance sheet. The U.S. effort that began in late 2017 with about $4.5 trillion on the Fed’s balance sheet, only managed to shrink by about $700 billion in October 2019, when acquisitions started to pick up again .

Federal Reserve Total Assets

Minutes from the Fed’s December meeting showed members discussed the balance sheet reduction without agreeing on timing or methods.

If bond prices were to fall sharply, any financial entity holding large debt securities would face large paper losses on a bond portfolio. As the value of their bonds fell, banks, insurance companies and similar institutions would need to raise additional capital.

Markets

The BoE’s early start in the policy race on Dec. 16 gave the pound a decisive trading advantage. The pound is the only major currency to appreciate against the US dollar this year. As of this writing, the amount of gain is not much, about half a digit at 1.3573. Against its new Brexit competitor, the Euro, the Pound’s valuation has risen around 1% since EUR/GBP closed the previous year at 0.8412.

The Federal Reserve has joined the anti-inflationary campaign with a rate hike scheduled for the March 16 meeting and a portfolio reduction that will begin then or shortly thereafter. By the end of this year, the BoE’s rate advantage should be gone as the Fed should, by itself in addition to most commentators, have acted forcefully against inflation.

The advantage of the BoE and the pound against the euro will improve in the second half. Although headline eurozone inflation was 5.1% in January, barely less than Britain’s rate of 5.4%, the European Central Bank (ECB) has only recently begun to acknowledge that the runaway prices are a problem. With the key ECB rate at 0%, continental yields need to rise further. The pound is already near its pandemic and seven-year highs against the united currency. Prior to June 2016, there were two years where the cross traded at 0.7000. Unless the ECB quickly changes policy, this territory remains open.

Gilt rates rose sharply in the new year. The 2-year yield is 36 basis points at the good at 1.02% and the 10-year has added 32 points to 1.29%. These are comparable to the increases in the United States where the 2-year Treasury yield gained 42 basis points to 1.15% and the 10-year to 27 points to 1.78%.

While markets priced in the BoE’s expected 0.25% rate hike on Thursday and the acknowledgment that portfolio cuts will begin in March, there is still plenty of room to maneuver in the last three quarters of the year. The BoE, like its Atlantic counterpart, is sensitive to economic conditions. If the UK economy slows or stalls, the BoE would pause its rates campaign even if it does not deny the overall objective of beating inflation with higher rates.

After the relative certainty of the first quarter, there is still no interest rate or market assurance for the rest of the year.

Jessica C. Bell