BOE gilt sales are a multibillion-pound mistake

The Bank of England cherishes its independence as a central bank free to decide monetary policy. But it's also an arm of the state with a duty of care to taxpayers. Its recent approach to reducing its vast pile of bond holdings
— at the same time as it aggressively raises interest rates — borders on dereliction. Massive losses are being taken on the sales, but the BOE is determined to stay the course.

In fact, Deputy Governor for Markets Dave Ramsden signaled in a July 19 speech that the Monetary Policy committee will decide at its September meeting to dramatically accelerate the sales. What disturbs me is the
emphasis that "importantly, the MPC does not take into account financial risk or profit when taking monetary policy decisions, including the gilt portfolio.” Shouldn’t they care about the taxpayer — a little?

The BOE has made clear it wants to return to its pre-pandemic balance sheet size of £500 billion ($650 billion). Having spent 13 years accumulating £895 billion — in an era of record low yields (and thereby very high prices) — it now wants a rapid unwinding. The point, according to Ramsden, is to provide headroom for a return to quantitative easing if the economy goes south. With UK growth flatlining, the margin for error by overtightening monetary policy is vanishingly slim. But there are some 500 basis points of interest-rate headroom to play with first before ever needing to reach for the QE button.

“We could be looking at a significant increase in the speed at which the BOE’s balance sheet is shrinking,” says David Owen of Saltmarsh Economics, who attended the speech. The impression Ramsden gave was that active QT gilt sales could exceed £60 billion next year, with the bank’s balance sheet possibly shrinking by  £125 billion  — including maturing debt — and £165 billion the year after.

As a percentage of gross domestic product,the BOE’s purchases weregreater than either the Federal Reserve or European Central Bank. In 2021, a House of Lords report called the BOE “addicted” to QE. It still owns over half of conventional  gilts issued but now it wants to purge itself without regard to the cost.

Jagjit Chadha, director of the National Institute of Economic and Social Research, has called for a comprehensive review, before deploying it again.
Hopefully, this one will not be conducted by the creator of modern QE and the resultant asset price bubbles: former Fed Governor Ben Bernanke,
who’s leading the review of the BOE's inflation-forecasting errors. That would be groupthink squared.

The BOE is fully indemnified by the UK Treasury, passing through completely any profits and coupon income - and now losses. A cumulative gain of £125 billion has not only been wiped out but mark-to-market losses exceed £150 billion. That's the equivalent of nearly three years of the total UK tax take from salaried workers.

The BOE was the first major central bank to start running down its holdings by not reinvesting maturing proceeds in February 2022. That is running seamlessly at a £40 billion pace but will nearly double next year. So why increase sales, known as quantitative tightening?

Since beginning in November, it’s been alone among the major central banks in pursuing active selling of its portfolio. It was forced to delay for a month as it cleared up the mess from Liz Truss’s gilt crisis, but it’s wasted little time since. Funnily enough, none of its central bank peers has rushed to join it as they watch gilt yields zooming above all other major bond markets. It also purchased £20 billion of corporate bonds in 2021 but has exited those holdings at significantly lower prices — and with sterling corporate bond credit spreads wider as a result.

State assets haven’t been disposed like this since then-Chancellor of the Exchequer Gordon Brown liquidated over half of the UK's gold holdings
at $275 per troy ounce. The BOE’s quarterly analysis shows the QT bill will be far bigger.

Not only is the BOE directly competing against the UK Treasury's Debt Management Office in weekly auctions, it's locking in staggering losses for the state — particularly in selling low-coupon long-dated holdings, which have collapsed in value. The gilt market is functioning better than during the 2022 crisis but volatility remains significantly higher than usual.

In longer-dated sales this year, it's sold a range of gilts at less than half of their purchased prices, realizing £15 billion in losses in very short order. These holdings could’ve been retained until prices recovered any time in over the next quarter century. There is a residual cost of about £20 billion per year to simply hold onto the portfolio, so holding every bond to maturity is not optimal. Nonetheless, it could select the least expensive to dispose that doesn’t distort the yield curve.

Hard to fathom is Ramsden's calculation that the £80 billion reduction in the BOE's holdings has only driven up gilt yields by 10 basis points. The BOE's belief is that QT is merely burbling along in the background according to its in-house analysis. In my cynical view, a survey of market participants, who have the most to benefit from knockdown prices, is sub-optimal.

Gilt yields have more than doubled in the past year, as official rates have been hiked 5 percent amid the largest supply of new gilts ever. The BOE has contributed to this extra supply at the worst time possible. It does share some of the responsibility - and that’s highly likely to be more than 10 basis points.

A selective approach from the central bank, rather than pre-planned auctions, would be a better commercial approach. Active QT can be a great way to reduce the bloated BOE balance sheet, but it should be limited until soaring gilt yields calm down. It's our money so treat it with respect.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Views are personal, and do not represent the stand of this publication.

Credit: Bloomberg