BOE Has More Than Rate Hikes to Worry About

(Bloomberg Opinion) -- In 2016, the Bank of England took a stab at estimating the interest-rate equivalent of its bond-buying program: The thinking then was that 60 billion pounds ($80 billion) of asset purchases were comparable to a Bank Rate cut of about 50 basis points.

How does the equation work when monetary policy goes in the other direction? Governor Andrew Bailey has been deliberately vague, a notable skill set of his, on what impact the reversal of quantitative easing will be. But in a matter of months we'll all have a clearer view.

A back-to-back rate hike to 0.5% at the Bank of England's monetary policy review on Thursday is not quite fully priced in — as might seem obvious with inflation roaring away and more than a million job vacancies. The sterling money markets are currently anticipating an 80% chance, whereas the Bloomberg survey of economists conducted earlier this month was split roughly in half. With recent whipsaw prevarications from the BOE, it is understandable market participants are careful in taking anything as assured.

The semantics of whether a hike comes this month or next are important, though, as there's more than interest rates at stake. It is whether the Monetary Policy Committee begins to run down its 895 billion-pound balance sheet, as it has clearly signaled will happen automatically once the bank rate reaches half a percent.

If the MPC refrains from hiking this week — I struggle to imagine what reasons they would plausibly cite for a delay — the impact on the U.K. government bond market would be disruptive. The upcoming maturity of the 4% March 2022 gilt, of which the BOE holds 28 billion pounds, would have to be reinvested. That would send the contradictory message of raising interest rates in December, then effectively restarting QE, even if only briefly. It would hardly embellish the already fragile reputation of the BOE's communication policies.

Gilt issuance has all but dried up in recent months but will increase substantially to one of the highest ever in the financial year starting in April. Net supply will more than double to over 80 billion pounds. As the BOE ended its QE purchases in December, there is no longer a friendly central bank behind the bid. Yields have responded to the ever louder beating of that drum, having risen substantially across the curve in recent weeks; it's more noticeable in the short end, as expectations have been priced in that the MPC will hike at least four times this year. Two-year gilt yields near 1% are the highest for over a decade.

If that transpires, then it could introduce an even more radical reduction of the BOE balance sheet; with official rates at least 1%, then the MPC will consider (careful choice of phrase there) active regular sales of its holdings. Analysts from HSBC Holdings Plc make a good point that the MPC, similar to the ultimately pointless preparation on negative rates, may choose to undertake a consultation of how that should be structured.

It is one of those suck-it-and-see moments, just as the Federal Reserve is contemplating a similar slam-it-into-reverse course. The BOE is one step ahead of its central bank counterpart but no longer too far in front after its surprise delay in November — and a damascene conversion to inflation fighting from Fed Chair Jay Powell since his renomination hearings.

A cost of living squeeze is coming at the U.K. consumer from all angles. How much of that will be as an indirect effect of the BOE reducing its balance sheet will not be clear for a while, but it's not going to be negligible. Some clarity behind the MPC's steps would be appreciated.

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Fed Does What's Expected, Not What's Needed: Mohamed El-Erian
Canada Traders Got Too Far Over Their Skis: Robert Burgess

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Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.