BoE’s second rate hike sounds a ‘QT’ horn: Mike Dolan

LONDON, Jan 28 (Reuters) – The big unraveling of bloated central bank balance sheets could begin as early as next week.

While investors have been in the grip of the US Federal Reserve’s hawkish anti-inflationary spin in 2022, the Bank of England is expected to raise UK interest rates for the second time in less than three months next Thursday and double its main key rate to 0.5. % In the process.

In August, the Bank announced that it would start shrinking its balance sheet as soon as base rates hit 0.5%, well below the 1.5% threshold it had previously set.

Unlike other central banks, the Bank of England comes under more pressure to shrink its balance sheet once rates rise, as its key policy rate is the very rate it pays commercial banks for the bank’s reserves. central created through the purchase of bonds.

The resulting maturity mismatches for the BoE’s assets and liabilities mean a sharp rise in interest rates and a flattening of the yield curve could see the BoE incur losses that the Treasury will eventually have to cover.

The government’s budget watchdog – the Office for Budget Responsibility – estimates that a one percentage point rise in rates could raise consolidated public sector liabilities by up to half a percent of gross domestic product in just 12 months.

But the combination of higher policy rates and a simultaneous pullback from the bond market could weigh heavily on financial markets and the broader economy.

Much like the Fed, the so-called “quantitative tightening” or QT process will be passive at first – the Bank will simply stop reinvesting maturing coupon payments and gilts and reduce its holdings as they arrive. due. Outright selling of stocks is likely a long way off and will likely depend on how the markets react to the passive QT first.

And that last bit makes it all feel like a lab experiment for the central banking community as a whole.

They’ve been here with the Fed before in 2018 and it was far from smooth. The markets wobbled strongly at the end of this year.

But the BoE’s move will mark the first balance sheet pullback since the massive explosion in government borrowing all around the pandemic – and will be an important marker for gauging how sustainable that bloated debt will be.

For the Bank, this leaves a considerable additional hole in the government bond market for private investors to fill. And economists are unsure how well Britain’s economy will be able to absorb a range of policy reversals this year – from rising borrowing and mortgage rates to rising taxes and soaring costs. household energy.

For other markets, a lot depends on how well the already aggressive BoE tightening, currently assessed, covers it all.

HSBC’s Dominic Bunning believes the first glimpse of the Bank’s balance sheet – which has soared to more than 40% of UK gross domestic product during the pandemic – will be a ‘big step’ but will not see a ‘sudden jolt’ in debt or sterling yields.

DOUBLE TIGHTENING

HSBC believes the run-off will be relatively soft at first, with the 72 billion pounds ($96 billion) that QT liabilities will reduce to the balance sheet by the end of next year less than 10% of the total holdings of the bank.

Bunning adds that while the Fed will start later, its passive QT will be much faster over this period – with almost 15% likely to disappear by the end of 2023.

Moreover, he believes that the already aggressive prices in the UK rates markets are likely to cover this “double tightening” effect at the moment and that the so-called “terminal rate” for Bank of England hikes will remain below that from the Fed. There was little historical evidence that changing the buying of gilts by foreign investors in the absence of the BoE would drive the pound higher, Bunning added.

The sharp drop in the pound against the dollar this week even as markets prepare for next Thursday’s BoE meeting and two-year gilt yields hit their highest level in 10 years is evidence of this. Britain’s two-to-10-year yield curve remains at its flattest level since the early stages of the pandemic – a third of what it was in the middle of last year.

Deutsche Bank’s Sanjay Raja said the bank had clear concerns that accelerating wage rises could keep UK inflation at its highest in decades as labor supply problems labor and goods persist well into the new year.

Even one of the Bank’s most dovish policymakers, Catherine Mann, acknowledged last week that the Bank must now “lean against” these pressures.

But Raja says early tightening measures – combined with the impact on UK demand from energy prices and tax hikes – should allow the Bank to slow the pace of key rate hikes even if it was selling its balance sheet more actively as rates hit 1.0. %.

Deutsche expects another rate hike in August, with two more six months apart in 2023, taking the terminal rate to 1.25%.

But there are clearly risks to this, given how the market is already priced. Futures markets are already forecasting rates at 1.25% by March next year and a terminal rate of around 1.5% in June.

“While not our base case scenario at this stage, a slightly more aggressive reduction in the Bank’s balance sheet should not be ignored and indeed seems somewhat more likely than before,” Raja wrote. .

The author is Finance and Markets Editor at Reuters News. All opinions expressed here are his own.

(By Mike Dolan, Twitter: @reutersMikeD; Editing by Edmund Blair)

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