Investors say that the Bank of England, when it announces its plans to reduce the size of the balance sheet in the coming week, should expand the types of bonds it offers to increase market liquidity.
In the last two-and-a half years, the BoE’s gilts portfolio has been reduced from £875bn (which was inflated by multiple rounds of quantitative ease stimulus) to £688bn. It does not wait for bonds to mature, but actively sells them.
The BoE will announce its plans at its September 19 policy meeting to shrink its balance over the next 12 months.
The central bank surveyed analysts who expect the sale of active gilts to continue at £100bn annually. This would be £13bn in the first year beginning October. However, a number banks, including JPMorgan Bank and Deutsche Bank, believe the BoE may increase its overall pace of gilt portfolio reduction to bring active sales in line with last year.
The sales will not cover maturities shorter than three years. Investors and investment banks strategists believe the central bank should also start selling gilts with maturities between one and three years.
Craig Inches is the head of rates, cash and Royal London Asset Management. He said that there was a noticeable liquidity problem on the short end gilt market. This was particularly pronounced in bonds, where [the BoE’s] Asset Purchase Facility holds a significant percentage.
He expressed his concern that the situation could worsen if the Labour Party, which is in power, increases the capital gains tax rate at the budget next month but leaves gilts CGT exempt. This would increase the demand for short-dated securities.
Bloomberg’s gilt liquid index, a widely-tracked measure of gilt marketliquidity, has declined to its lowest level since 2008 at the height of the global financial crises. It still shows worse liquidity than the 2022 market crisis.
Moyeen Muhammad, Barclays gilts analyst, says that the most notable decline in liquidity was in gilts of one-to-three-year maturities. This is partly because of the BoE’s large stockpile. About £225bn or a third of the BoE gilt portfolio is made up by shorter-dated bonds.
Islam said that this has caused them to be “structurally rare”. Start selling gilts from bonds that have a maturity of one year “would help”. . . He added.
Investors are concerned that a lack of liquidity on the short-dated gilts markets could cause problems in the repo marketplace, where high quality collateral like gilts is temporarily traded for cash.
Investors are concerned that the yields could be suppressed by a shortage of short-dated assets if demand exceeds supply.
Mark Capleton is a Bank of America strategist. He said that selling front-dated gilts would have multiple benefits. It could be a good substitute for reserves, as banks will be more willing to purchase them at the best price.
The BoE has suffered losses on bonds that it purchased when interest rates were lower and have now matured or sold for less than what it paid. The bank will focus on QT at its monetary policy meeting in the coming week. It has cost the government around £22bn during the last year.
Capleton stated that the BoE’s losses would be “proportionally less” as bonds with shorter maturities are traded at a smaller discount to parity compared with bonds with longer maturities.
The BoE said it would reduce its holdings of gilts at least up to the point where reserves are scarce. This is estimated at between £345bn and £490bn.
Analysts believe the central bank can increase the QT pace, since it has stated that it believes its sales will have little effect on gilt prices. A higher volume of gilts are due to mature in the next year.
Tomasz Weiladek, economist at T Rowe Price, said that they could increase the pace of the QT to £120bn. This would be more in line with the active pace during the previous years. He said that the BoE’s short-term refinancing facility would allow the bank to reduce its balance sheet more quickly, as long as the economy and markets are favourable.
Analysts warn that the BoE must tread carefully when it comes to its preferred minimum reserve level. This is inherently unreliable.
In recent months, the use of BoE’s short term repo facility has exploded. This facility was created in 2022 in order to assist borrowers, primarily banks, access short-term funds. Investors borrowed £40bn last week, a record amount compared to the £700mn they borrowed in the first weeks of the year.
BoE policymakers insist that the increased use of this facility is not indicative of liquidity problems, but some analysts claim it’s linked to shortages on certain parts of the market.
Imogen Bachra of NatWest’s non-dollar rate strategy said that the BoE may be approaching its preferred range for minimum reserves “perhaps slightly sooner than previously thought”.
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