The 10-year gilt yield at 3.8% is noticeably higher than the 3.5% on its US equivalent. UK debt has also underperformed German bunds by more than 60 basis points since early February, despite the European Central Bank being even more determined to keep raising interest rates than its UK counterpart.
This is partially due to worse UK economic data, such as inflation remaining stubbornly above 10%. But the main reason for this gilt yield premium is too simply many bonds on offer. The BOE has about-turned — from being the largest net buyer over the prior decade to becoming an active seller — a little too quickly for the market to digest. It doesn’t help that foreign investors sold £36 billion of UK debt in the first quarter, reversing all of last year’s net purchases. According to Bloomberg Intelligence Strategist Huw Worthington, much of this probably isn’t actually overseas funds but UK money from pension funds domiciled in tax-efficient European centers divesting gilts after last year’s turmoil.
The backdrop to all of this is the Treasury’s Debt Management Office aiming to raise a record £240 billion in gilt sales this financial year — more than the prior seven years of net cumulative supply. Most weeks see both the DMO and the BOE separately selling gilts, with the former funding government spending and the latter seeking to reduce its balance sheet. There will be an important test of pension fund demand on Tuesday with the syndicated sale of a new 40-year gilt bearing a 4% coupon — the highest since 2008, reflecting the surge in yields.
It might help if the BOE stopped crowding the space. It’s the only major central bank that’s marking the end of quantitative easing by liquidating its holdings back into the secondary market; its peers are restricting themselves to not reinvesting the proceeds of maturing bonds. The BOE has the freedom to suspend sales, as it did during the gilt crisis, when dysfunction creates “fire-sale” dynamics. It could just interpret that to include times when yields are too high. That would show a duty of care to the market, even if it might conceivably threaten to undermine the BOE’s prized independence.
The central bank is keen to steadily reduce its balance sheet to pre-pandemic levels of less than £500 billion. The BOE swiftly exited its October financial stability gilt purchases for a tidy profit – and it’s also close to running down its entire £20 billion corporate bond portfolio. Nonetheless, these are dwarfed by its £812 billion of gilt holdings; its current strategy is to reduce this by around 10% annually.
Half of this occurs by passively not reinvesting maturing debt, which has run smoothly since March 2022. This runoff does have lumpy large maturities, though, so the other half of the program is ”active” sales to smooth the placements. Active QT involves selling around £10 billion each quarter, which is relatively modest compared to DMO sales more than six times larger. About £38 billion of the gilt portfolio matures this financial year, but that will double in the following year. If the annual £80 billion pace persists, then active sales will be sharply cut back next year anyway. So why not reduce it now, restarting the program when there is less upward pressure on yields?Bear in mind that higher yields affect the wider economy as corporate debt is priced off government benchmarks. In comparison, the ECB estimates that its much smaller passive program, which only began this March, has led to an increase of 60 basis points to 70 basis points in 10-year government borrowing costs. The upward effect on the UK yields can only be greater.
Gilts are certainly cheap on a relative basis to other bond markets, but a temporary reduction in supply could turbocharge a much-needed drop in borrowing costs. It helps that the DMO issuance schedule tapers off later in this quarter. The other swing factor is when the BOE finally pauses rate hikes. BOE Chief Economist Huw Pill said on Friday that inflation might be at a “turning point,” echoing remarks the previous day from Governor Andrew Bailey. The sharp upward revisions to growth and inflation forecasts at the May monetary policy review last week leave room for future positive surprises.
The bill for the QE experiment was always going to soar once interest rates rose from zero. These extra costs are firmly on the UK taxpayer, and generations beyond. It would be joined-up thinking if the central bank could choose its timing better, and help reduce an unnecessary surge in the UK yield premium.
More From Bloomberg Opinion:
• Who’s Not Sweating the Debt Ceiling? The Markets: Nir Kaissar
• BOE Should Avert Its Gaze From Rear-View Mirror: Marcus Ashworth
• BOE Makes Progress But Will Need Some Help: Mohamed El-Erian
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.
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