BOE’s Bond-Buying Program Creates Wrinkles in Gilts’ Yield Curve

Updated on
  • 2-, 3-year spread turns negative for the first time in 8 years
  • Unclear if expanded gilt QE will be effective: Credit Agricole

The Bank of England’s renewed bond-buying program is already creating signs of distortion in the $2.2 trillion U.K. gilt market.

Three-year gilts have yielded less than their two-year counterparts since Aug. 4, when the new round of purchases was announced, in their first so-called yield-curve inversion in almost eight years.

The central bank started buying government securities again on Monday as part of its suite of stimulus aimed at heading off economic fallout from Britain’s decision in June to leave the European Union. It kicked off the program with a 1.17 billion-pound purchase of shorter-term gilts, with two-year debt excluded from the program.

Yield-curve inversions are the very kind of market anomalies that investors and analysts watch out for. When the BOE started its quantitative-easing program in 2009, gilt issuance was at a record high as the government needed to borrow more to deal with the crisis-hit economy, and 10-year yields were above 3 percent.

Return of QE

The latest round of QE is taking place after issuance has dropped by more than 40 percent from that level and 10-year gilt yields have fallen below 0.6 percent. The easing policy has caused longer-dated bond yields to fall. While that is probably good for borrowers, the downside is that it may hurt banks’ profitability and force consumers to save more to make up for shortfalls in earned interest.

“The market is watching this sovereign bond-buying program closely,” said Mohit Kumar, head of rates strategy at Credit Agricole SA’s corporate and investment-banking unit in London. “While it’s likely to lower longer-maturity yields, it’s not obvious at this point, on its own, how effective it will be given yields are already very low.”

Click here to see an analysis of how a weaker pound may not offset an industrial slowdown

Policy makers reduced growth forecasts in their latest analysis last week. The Monetary Policy Committee’s measures include the first rate cut since March 2009, a plan to buy 60 billion pounds of government securities over six months, as much as 10 billion pounds of corporate bonds in the next 18 months and a potential 100 billion-pound loan program for banks. Governor Mark Carney declared that all elements of the stimulus can be taken further.

Record Low

The yield on benchmark 10-year gilts dropped three basis points, or 0.03 percentage point, to 0.58 percent as of 4:48 p.m. London time, having dropped earlier to a record-low 0.56 percent. It has fallen by more than 20 basis points since just before the BOE announced its policy decision on Aug. 4.

The 2 percent security due in September 2025 rose 0.295, or 2.95 pounds per 1,000-pound face amount, to 112.535. The gain was helped by result of the second round of purchases, held Tuesday, when the BOE failed to meet its buying goal.

Two-year gilts were yielding about three basis points more than those due in three years. The last time the difference turned negative was in October 2008. The yield gap between two- and 30-year gilts narrowed four basis points to 128 basis points, also the least in almost eight years on a closing basis, as investors moved further up the curve to grab higher returns.

When viewed as part of a package of measures rather than in isolation, the expansion of gilt buying is more likely to benefit the economy than not, according to Kari Hallgrimsson, London-based head of sterling-rates trading at JPMorgan Chase & Co.

Fiscal Policy

Chancellor of the Exchequer Philip Hammond has said he’s ready to “reset” fiscal policy and has signaled that additional borrowing may be on the way. Yet, investors have taken that in stride. Gilts are the best performers this year among developed markets’ sovereign securities, returning 16 percent, according to Bloomberg World Bond Indexes.

“It is a positive policy response,” said Hallgrimsson in a phone interview. “It gives room for the Treasury to look at fiscal stimulus. Those two measures together will be effective in combating the uncertainty that has arisen due to the Brexit result.”

For Mark Dowding, the inversion at the short end of the yield curve is not as important as a steady decline in longer-dated yields, which he said could undermine what the BOE is trying to achieve.

“The more yields fall at the longer end of the curve, the worse pension deficits become,” said Dowding, a London-based partner and money manager at BlueBay Asset Management. “This means that as companies plug pension black holes, there is less left to invest, fewer jobs and weaker growth.”