Over the past decade, the BoE has been the largest single market supporter of gilts through its structural QE buying programs. Current optics suggest a hastening retreat from the then-biggest sponsor of gilts.
This will likely reintroduce term premia into gilt market at a faster pace, pressuring UK long-term bond yields higher (and dragging bond prices lower).
It's negative impact is most pronounced in long gilt maturities; so-called ‘duration effect’ and should result in more pronounced curve steepening.
The BoE’s own internal models suggests a 0.4 per cent increase in term premium since QT started. It also admits difficulties in precise estimation of the impact of asset sales on Gilt yields. There is no historical precedence for QT, and only a year of empirical evidence.
Admittedly, rising UK term premia is not solely due to the BoE’s QT program.
Investors are also demanding additional premium for inflation protection (and UK’s inflation profile is sticky versus peers), while larger than expected government borrowing is weighing on demand, particularly from foreign investors.
In addition, last year’s market fallout from UK mini-"Budget" left a bitter taste amongst investors. Going into an election year, it remains unclear whether good fiscal policies will prevail, or the government may be tempted into spending giveaways.
The latter would be quite negative for UK gilts, hence sentiment remains on the edge.
Overall, UK fixed income markets have been quite volatile, liquidity is challenging, the outlook remains uncertain, and investor sentiment remains poor.
The BoE could have opted for a slower and gentler balance sheet run-off profile. We are surprised.
Prepare for bumpier times ahead.
Brian Marwingo is an investment manager within the multi-asset team at Barings
