If all goes to plan – a big "if" these days in the United Kingdom – the Bank of England will begin the process of actively selling Gilts back into the market on November 1, becoming the first major central bank to take such a step. It will be a move that will be closely watched by officials and finance professionals around the world as a gauge of how a decade of ultra-loose monetary policy can begin to be unwound.
After a false start at the end of last month and much speculation that the BoE would delay Gilt sales, the UK's central bank confirmed on October 18 that active quantitative tightening would start at the beginning of next month and run until December 8 through eight auctions with a planned size of £750m each.
How central banks will extricate themselves from quantitative easing and finally shrink their massively inflated balance sheets is a question that has been playing on market participants' minds. While the BoE began passive QT (letting bonds mature and not reinvesting the principal) earlier this year, its move to actively sell down its holdings of Gilts will be a closely watched gauge of how investors respond and how the market copes when there are two sellers of government debt – the BoE and the UK Debt Management Office.
"For the first time in history, you will have two sellers of Gilts, not one," one senior DCM banker said, noting there will be tension between the two sales routes, especially as the DMO has an established system to sell Gilts, which the BoE lacks. The DMO system relies on so-called Gilt-edged market makers – a group of banks signed up to offload primary Gilts into the market via syndications and committed to be active at auctions.
"Gilt market makers are obliged by condition of being market makers to bid at DMO auctions. There's also the carrot of getting a syndication if you bid at the auction. With the Bank of England, there will be none of that. Why would you turn up to a Bank of England auction or buy bonds from someone who's never sold them? Why would anyone think the Bank of England doing their own auctions is a smart idea? Why would you compete with the DMO from whom the GEMMs are effectively obliged to buy bonds?" the banker said.
Tricky times
The issue is particularly pressing given the ructions the Gilt market has gone through in recent weeks.
"It is very much going to be about end-investors. Dealers aren't going to be taking [big] sizes down. Not because they don't want to necessarily but more because they don't have capacity," another senior DCM banker said.
An investor said his willingness to buy from either the DMO or the BoE would simply depend on his risk appetite at the time.
One head of SSA syndicate said he was doubtful the BoE would be able to reach the numbers it has targeted for its early sales. "The expectation is that they won't be able to get close to the size that they want to sell at the beginning – but let's see," he said.
The BoE's Gilt portfolio has a face value of more than £857bn (£838bn accumulated via QE purchases, plus another £19.3bn from its recent emergency purchases as it sought to stabilise markets).
All involved acknowledged the risk that the extraordinary volatility of recent weeks will make investors more wary of buying UK government debt just at a time when the market will be flooded with Gilts from the BoE and as the DMO increases its issuance requirement as a result of needing to fund energy price subsidies.
Already, the BoE has amended its original plan of selling Gilts in short, medium and long-maturity buckets. It will instead focus on short (three to seven years) and medium (seven to 20 years) instead, avoiding long-end bonds often held by pension funds using LDI strategies that have heavily been impacted by the volatility.
Carefully does it
Robert Stheeman, chief executive at the DMO, said his institution and the BoE had worked hard to coordinate their activities as much as possible.
"If you look carefully at what the Bank announced as a follow-on from the last MPC meeting, and what was in our revised remit announcement the following day, you can see that there is a clear desire by the Bank and the DMO to try and avoid operating on the same day," he told IFR at the end of September. "As the Bank has said previously, in designing a strategy for Gilt sales, it has liaised with us in order to minimise interference with our issuance programme. The desire not to cause unnecessary friction between the two authorities is very strong with both of us."
The DMO said it would syndicate a 15-year bond the week commencing November 7. A BoE auction of medium-term Gilts is scheduled on November 7.
"Trying to get investor feedback on this right now is extremely tough, as you can imagine," the head of SSA syndicate said. "If you're asking them what they think of a 15-year syndication that week in November, they just laugh at you."
Not everyone is gloomy, however, and the BoE's change of tack on tenors has been welcomed, especially given the squeeze at the short end.
"If you look at the demand, the short end is where it is," another senior syndicate banker said. "If you look at valuations versus swap spreads, which are very rich, and what's happening with the LDI community, I would expect demand for short-dated paper to be strong. In our view, the Bank selling into the market will actually relieve some of the distortions created by the Bank owning so much of the free-float in the first place."
Pooja Kumra, senior European and UK rates strategist at TD agreed, though she said the market would likely build concessions going into the auctions. "For me, there's definitely more risk for the market taking down medium-term debt until we get more political stability," she said. "QT was well telegraphed and it's a very small way of reducing the BoE's balance sheet. I think the bigger risk right now is [what happens with] the government."
Corrects to amend wording of syndication timing