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The Bank of England should broaden the range of bonds it sells in order to boost market liquidity when it lays out plans to scale back the size of its balance sheet next week, investors say.
Over the past two and a half years the BoE has shrunk its gilts portfolio — which was swelled by numerous rounds of quantitative easing stimulus — from nearly £875bn to £688bn. Unlike other central banks, it is not just waiting for bonds to mature but is also actively selling them.
At its policy meeting on September 19, the BoE will announce plans for how much it will shrink its balance sheet by over the coming 12 months.
Analysts polled by the central bank expect it will continue at £100bn per year, which would include £13bn of active gilts sales in the year starting October. But a number of banks — including JPMorgan and Deutsche Bank — think the BoE might increase the overall pace of its gilt portfolio reduction so as to bring active sales closer in line with the past year.
However, the sales will only cover maturities of three years or longer. Investors and investment bank strategists say the central bank should start selling gilts that mature within one to three years too.
“There is a notable liquidity problem in the short end of the gilt market, particularly focused in bonds where the [BoE’s] asset purchase facility holds a large percentage,” said Craig Inches, head of rates and cash at Royal London Asset Management.
He said he feared it would get worse if the ruling Labour party increases the rate of capital gains tax at next month’s budget but keeps gilts CGT-exempt, as this could increase demand for short-dated bonds.
Bloomberg’s gilt liquidity index — a widely tracked measure of gilt market liquidity — has deteriorated to its worst level since the depths of the global financial crisis in 2008 last month and is still currently showing poorer liquidity than during the 2022 gilt market crisis.
The most significant worsening of liquidity has been in gilts with a one to three-year maturity, in part because the BoE built up such a large stockpile of these bonds, according to Moyeen Islam, a Barclays gilts strategist. Shorter-dated bonds make up about £225bn, or one-third, of the BoE’s gilt portfolio.
That has made them “structurally scarce”, said Islam. Starting gilt sales from bonds with a one-year maturity “would help . . . functionality and liquidity of the market”, he added.
Investors worry that poor liquidity in the short-dated gilts market could create problems in the repo market, where high-quality collateral such as gilts is temporarily exchanged for cash.
The repo market is usually used by the central bank to help set its official interest rate, but investors worry that yields may be suppressed if demand for short-dated assets outstrips supply.
“Selling front-dated gilts has multiple benefits — it provides a close substitute for reserves as banks should be happier to buy them at the right price,” said Mark Capleton, a strategist at Bank of America, adding that it would help the BoE shrink its balance sheet more smoothly.
The BoE has made losses on bonds it bought when interest rates were low and which have matured or been sold at a lower price than it paid. QT will be a focus of the bank’s monetary policy meeting next week, as it has cost the government about £22bn over the past year.
However, Capleton said that losses crystallised by the BoE would be “proportionally smaller” because bonds with short-dated maturities trade at smaller discounts to par compared with longer-dated bonds.
The BoE has indicated it will reduce the level of gilts it holds at least until the point at which reserves become scarce, which is estimated to be in the range of £345bn to £490bn.
Some analysts think the central bank could increase the pace of QT, as it has explicitly said it thinks that its sales have little impact on gilt prices and a higher volume of gilts is set to mature next year anyway.
“They could easily raise the pace of QT to £120bn, as this would be closer to the active QT pace in previous years,” said Tomasz Wieladek, an economist at T Rowe Price. He added that as the BoE is encouraging the use of its short-term repo facility, it would help to run down its balance sheet as quickly as it can, which is easier while the economy and state of markets allow it.
But analysts warn the BoE should tread carefully as it approaches its so-called preferred minimum reserve level, which is inherently uncertain.
The use of the BoE’s short-term repo facility, which was set up in 2022 to help borrowers — predominantly banks — access short-term cash, has shot up in recent months. Last week investors borrowed a record £40bn from the facility, compared to just £700mn in the first week of this year.
BoE policymakers have insisted that increased use of the facility was not a sign of liquidity issues, but some analysts argue it is linked to shortages in parts of the market.
Imogen Bachra, head of non-dollar rates strategy at NatWest, said the BoE could be closing in on its preferred minimum reserve range “perhaps slightly earlier than previously thought”.
