Carney Stimulus Exit Posing QE Challenge for BOE: U.K. Credit

Bank of England Stands in London
The Bank of England last increased its bond-buying target in July 2012. Photographer: Matthew Lloyd/Bloomberg

Bank of England Governor Mark Carney has more than just interest rates to think about as investors begin speculating on how policy makers will unwind their 375 billion-pound ($624 billion) bond-buying program.

Quantitative easing has left the BOE with about 28 percent of total gilts outstanding, an amount Carney today ruled out selling in full. With the economic recovery becoming entrenched, the 10-year yield has doubled from its record low in 2012, underlining the challenge facing the central bank as it tries to navigate the transition from emergency stimulus without driving up borrowing costs for households and companies.

“There must be a premium somewhere in the curve to reflect the fact that there is a non-zero risk of gilt sales from the Bank of England,” said Simon Peck, a rates strategist at Royal Bank of Scotland Group Plc in London. “Ten- to 20-year yields are where you can see the QE themes and debates coming to the fore in terms of yield impact. Relative to the natural demand that you get, the impact is more pronounced at the belly of the yield curve.”

The additional yield investors demand to hold 10-year gilts over their two-year counterparts has climbed almost 10 basis points to 214 basis points over the past week and Peck expects the gap to keep widening. The spread will reach 260 basis points by the first quarter of next year, according to a Bloomberg survey.

‘Relatively Long’

The BOE last increased its bond-buying target in July 2012. The 10-year gilt yield, which fell to a record-low 1.41 percent in that month, was 2.78 percent at 4:18 p.m. London time as investors bet officials will increase interest rates from a record-low 0.5 percent next year.

The BOE said in its Inflation Report last month it intends to maintain the stock of assets it accrued in the QE operations at least until the first increase in its key interest rate.

Testifying to lawmakers today, Carney ruled out selling the BOE’s entire gilt holdings and said sales should only begin after “several” interest-rate increases.

“We need a predictable schedule in my opinion for rolling off our gilt portfolio when the time comes,” he told Parliament’s Treasury Committee in London. “A lot of things need to happen before that. One option is not to reinvest as those gilts matured. That is not the current intention of the Monetary Policy Committee. We will not reconsider that intention at least until we adjust Bank Rate.”

New Confidence

Carney’s comments today should provide gilt holders with new confidence that not all the central bank’s holdings will be sold back into the market, Sam Hill, senior U.K. economist at RBC Capital Markets in London, wrote in an e-mailed note.

One-month forward contracts for the sterling overnight interbank average, or Sonia, signal the central bank will boost the key lending rate by 25 basis points by April 2015. They show the rate reaching 1 percent five months later and 2 percent in January 2017.

Peck at RBS says the first sale of bonds may come when the bank rate reaches 1 percent, while Philip Shaw, an economist at Investec Securities in London, says borrowing costs would have to be around the 2 percent inflation target before the BOE begins divesting its holdings. Almost half of respondents to an RBS survey published March 3 expect the gilts will be held to maturity.

Failed Auction

“If they were simply to let the gilts mature then that would be a long-term process,” Shaw said. “Whichever way you look at it, it’s going to take a while for the bank to ditch all its QE gilts.”

As quantitative easing got under way in March 2009, Britain failed to find enough buyers at an auction of gilts for the time in almost seven years, underlining the potential for disruption.

Debt Management Office Chief Executive Officer Robert Stheeman says the agency will not be changing its strategy as the central bank considers what to do with its QE portfolio.

“We do not seek to second guess what the Bank of England might do, and I think that’s a very good thing in terms of not sending wrong signals to the market,” he said in an interview on Feb. 25. “What we will not do is change our issuance strategy in anticipation of anything the bank might or might not decide.”

The MPC maintained its policy settings at its meeting ended March 6, marking the fifth anniversary of rates being at 0.5 percent. The bank also said it would reinvest 8.1 billion pounds of maturing gilts in operations starting this week and announce further purchases on a weekly basis.

“We are dealing with an unprecedented thing,” former Chancellor of the Exchequer Norman Lamont said in a BBC interview last week. “There have been things like QE in the past, but never, ever, on this scale. That is a dangerous situation. I don’t believe it can just go on and on without some consequence.”

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