Bond navigators: The Bank of England's changing quantitative tightening plan and the gilt market

On Thursday (17 September) the Bank of England (BoE) voted to keep UK Base Rates at 3.75% by a majority of six to three, an outcome that had been widely forecast by the bond markets. Almost no-one expected that the BoE would follow in the footsteps of both the European Central Bank and the US Federal Reserve in adjusting monetary policy by raising rates.

While there are diverging views amongst members, the majority have given weight to the relative weakness of growth and the labour markets for some time, and noting there has been "little sign so far of indirect effects", and second-round effects from elevated energy prices. However, that narrative is shifting, with the committee acknowledging that growth had been stronger than expected, and that there are signs of stabilisation in labour markets. Most importantly though, is that oil and natural gas prices remain elevated, and evidence is growing that global weather patterns this year might have a greater than usual effect on next year’s food prices, which have been the core driver of recent undershoots in UK inflation prints. The BoE has, as a result, adjusted expectations of where inflation might peak to just above 4% in Q1 next year.

Bond markets have been expecting a shift in narrative for some time; November is around 80% priced for a 0.25% increase in Bank Rate, with an additional three hikes forecast for next year, thus taking UK base rates to 4.75%. It should be noted that earlier in the week, markets were pricing around five hikes from the BoE, which would, if delivered, take Bank Rate to 5%, just a little below the 5.25% peak seen in 2023. Our view is that this is too high, and with UK government bond yields close to their cycle peaks, we have continued to see value, particularly in three to seven year maturity gilts.

At Thursday’s meeting the BoE updated the market on its plans for its quantitative tightening program.

But the most interesting and market moving announcement had little to do with the above. At Thursday’s meeting the BoE updated the market on its plans for its quantitative tightening (QT) program. For the past few years, the BoE has been doing “passive” and “active” QT. The passive element allows for shorter maturity bonds to mature without re-investing the proceeds, while active QT encompasses the sale of bonds back to the market. For some time, we have been calling for the BoE to stop selling longer maturity bonds as part of these operations – particularly given that the UK debt management office has done everything it can over the past 18 months to drastically reduce the sale of longer maturity bonds as part of its ongoing finance requirements. On Thursday, the BoE delivered, permanently scrapping the sales of UK gilts with a maturity beyond 2049. Furthermore, all active bonds sales will be suspended until April 2027, when the new operational details will be announced.

The reaction from the bond markets was decisive, with longer maturity bonds dramatically outperforming on the curve.

The reaction from the bond markets was decisive, with longer maturity bonds dramatically outperforming on the curve. With rate hikes well priced, curves steep, and bond yields close to their peaks, and with policy makers seemingly determined to defend longer maturity bond yields, investors should now consider whether it is the right time to be shifting out of shorter maturity exposure into longer maturity exposure. In our view, the all-in yield and carry is starting to become relatively powerful.

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