More Important Than the Interest Rate Decision! Bond Investors Closely Watch the Bank of England’s QT Plan

According to Zhitong Finance APP, the Bank of England will announce its latest interest rate decision at 19:00 Beijing time on Thursday. The market generally expects the Bank of England to keep the benchmark interest rate unchanged at 3.75%. However, the energy price shock triggered by the Middle East war is sparking intense debate among policymakers and investors over whether to raise rates. Investors are particularly focused on whether the Bank of England will hint that surging energy prices could force it to follow the Federal Reserve in raising rates.

If the Bank of England releases a hawkish signal, UK government bond yields may rise as a result. However, for bond investors, they are more focused on the Bank of England's quantitative tightening (QT) plan for the coming year rather than Thursday's interest rate decision. The Bank of England will also publish its annual update on Thursday, which covers its latest plans to reduce its balance sheet through the sale of government bonds.

The focus for the bond market is whether the Bank of England will reduce or even suspend its active sales of bonds from the balance sheet; any reduction in the scale of active bond sales by the Bank could be positive for UK government bonds.

Since February 2022, the Bank of England has cut its bond portfolio from nearly double its previous size to £489 billion. The bank stated its goal is to sell all its bond holdings, following three principles: interest rates remain the main tool of the Monetary Policy Committee (MPC); bond sales will not disrupt market functioning; and the unwinding process should be gradual and predictable.

Evelyne Gomez-Liechti, strategist at Mizuho, said: "QT is the more important market event. The significance of the related announcement may outweigh the interest rate decision." Her base scenario is that the Bank of England would abandon its active bond sales and instead conduct only passive QT, meaning bonds naturally roll off its balance sheet as they mature. She stated this would provide support for UK government bonds.

The Bank of England's QT plan involves gradually unwinding the UK government bonds purchased during the pandemic-era quantitative easing (QE). These bond sales have been closely watched by the market, as they could increase selling pressure, and the latest wave of selling has already pushed long-term funding costs in the UK to their highest levels since 1998, eroding the government's fiscal space.

UK long-term government bond yields remain near highs last seen in 1998

Remi Olu-Pitan, Head of Multi-Asset Growth & Income at Schroders, said: "I do think that, as the lender of last resort, the institution will ultimately have to step in at some point to support UK government bonds. I believe that if UK bond yields continue to rise, action will be necessary."

Morgan Stanley strategists Fabio Bassanin and Luca Salford stated that "the substantial increase in UK government bond issuance and the decline in Bank of England holdings" have had a particularly notable impact on long-term UK government bonds, while in recent years pension funds' demand for such bonds has weakened. They estimate that QT has caused 30-year UK government bond yields to rise by an additional 70 basis points.

Data shows that the premium on 30-year UK government bonds relative to comparable swap rates—a key indicator of market concerns over bond supply—has generally remained stable this year, even as yields soared.

Surveys show that market participants expect the Bank of England may slow the pace of balance sheet reduction to £50 billion ($67 billion) per year in the 12 months to October. This means the scale of active UK government bond sales will be about £20 billion. However, a report earlier this week said the Bank of England may completely stop selling long-term debt, reigniting market discussion on the matter.

Given that the Bank of England is currently incurring losses when selling long-term UK government bonds—costing the government billions of pounds—the plan has come under criticism. However, even if the Bank of England stops selling UK government bonds, the impact may only be marginal since UK bonds remain vulnerable to external shocks, such as a Middle East conflict pushing up oil prices and heightening inflation concerns.

QT has limited impact on long-term UK government bonds

Some market participants warn that given the Bank of England's concern that changing its bond selling strategy to accommodate government fiscal needs could raise questions over central bank independence, it may refrain from making any major moves outside consensus expectations. Citi strategist Jamie Searle said that while changes in strategy are possible, he suspects the Bank of England will "maintain the status quo to avoid muddling QT's monetary policy control."