Barclays: Bank of England slowing balance sheet reduction pace expected to ease pressure on repo market and UK gilts

The Bank of England kept its benchmark interest rate unchanged at 3.75% on Thursday as expected, but simultaneously warned that it may need to raise rates if the Middle East conflict intensifies inflationary pressures. At the same time, the Bank of England made a major adjustment to its quantitative tightening (QT) plan, announcing it would abandon sales of long-term government bonds and plans to gradually reduce its 488 billion ($650 billion) debt portfolio by 2034. Under proposals that have not yet been finalized, the Bank of England will retain 120 billion of government bonds maturing in 2049 or later, matching them against future banknote issuance. Another 222 billion of government bonds maturing before 2035 will be allowed to run off naturally, while the remaining 146 billion maturing between 2035 and 2049 will be sold at a pace of 20 billion per year, and may be sold directly to the government through the Debt Management Office (DMO). All planned QT auctions will be suspended until April next year to allow the terms of sales to the DMO to be finalized. The move is intended to avoid competing with government bond issuance, thereby easing short-term pressure on UK gilt yields. Barclays strategists said the Bank of England's plan to slow the pace of bond sales will ease pressure on repo operations and also provide support for pressured ultra-long UK gilts. Strategist Moyeen Islam wrote in a report that the move "creates a very favorable environment for long-end UK gilt spreads and the long end of the yield curve, because there is a genuine shortage of bond supply in the market, and that shortage is unlikely to be alleviated in the foreseeable future." The Bank of England has also "in effect relieved some of the operational pressure on its repo operations." The Bank of England's short-term repo facility provides sterling liquidity to the market using UK gilts as collateral. The scale of these operations had previously grown faster than the pace at which the Bank of England withdrew reserves through the Asset Purchase Facility, which holds the bonds the Bank of England bought during its quantitative easing program. Active quantitative tightening (QT) drives increased use of short-term repo operations A slower pace of balance sheet reduction by the Bank of England should allow both short-term and long-term repo operations to grow at a more gradual pace, giving the Bank of England greater control over the process of the banking system moving toward equilibrium reserve levels. At the same time, some UK gilts may become increasingly scarce. According to Barclays' calculations, among the Bank of England's legacy holdings, there are still seven gilts maturing between 2029 and 2034, six of which have 30% to 50% of their outstanding balances held by the Asset Purchase Facility. Given the limited prospect of new supply, the amount of bonds available for trading or lending may decline further over time, making these gilts relatively more expensive and more in demand in the repo market. Some of the longer-dated gilts held by the Asset Purchase Facility may become candidates for the DMO's tender program. That program aims to ease market mismatches by selling non-benchmark gilts and taking advantage of lower yields. Moyeen Islam said the new system still has some "details" that need to be further resolved, including how the DMO will dispose of the UK gilts it receives. He said the September meeting minutes "implicitly mentioned the Monetary Policy Committee's (MPC) discussion of the DMO's 'ability to cancel bonds,' but this matter would need to be implemented only after consultation with the market."