Barclays: The Bank of England's slower pace of balance sheet reduction is expected to ease pressure on the repo market and UK government bonds

According to Golden Ten Data APP, the Bank of England left its benchmark interest rate unchanged at 3.75% as expected on Thursday, but also warned that an escalation of conflict in the Middle East could require a rate hike if inflationary pressures intensify. Meanwhile, the Bank made a significant adjustment to its quantitative tightening (QT) program, announcing that it would abandon the sale of long-term government bonds and instead plans to gradually reduce its £488 billion (about $650 billion) debt portfolio by 2034.

According to a proposal yet to be finalized, the Bank of England will retain £120 billion of government bonds maturing in 2049 or later to match future banknote issuance. Another £222 billion of bonds maturing before 2035 will mature naturally, while the remaining £146 billion of bonds maturing between 2035 and 2049 will be sold at a rate of £20 billion a year, and may be sold directly to the government via the Debt Management Office (DMO). All planned QT auctions will be suspended until next April to finalize the terms of sales to the DMO. This move aims to avoid competing with government bond issuance, thereby easing short-term pressure on UK government bond yields.

Barclays strategists said the Bank of England's plan to slow the pace of bond sales will alleviate pressure on repo operations while also supporting stressed ultra-long-dated UK government bonds. Strategist Moyeen Islam wrote in a report that this move “creates a highly favorable environment for long-term UK government bond spreads as well as the long end of the yield curve, because the market is experiencing a genuine shortage of bond supply, which is unlikely to be alleviated in the foreseeable future.” The Bank of England has also “in effect reduced some of the operational pressure facing its repo operations.”

The Bank of England’s short-term repo facility provides sterling liquidity to the market using UK government bonds as collateral. The scale of these operations had previously grown faster than the pace at which the Bank is draining reserves through its asset purchase facility, which holds bonds acquired during the quantitative easing program.

Active quantitative tightening (QT) increases usage of short-term repo operations

By slowing the pace of balance sheet reduction, the Bank of England should enable both short-term and long-term repo operations to grow at a more gradual pace, giving the central bank greater control over the banking system’s progress toward equilibrium reserve levels.

Meanwhile, some UK government bonds are likely to become increasingly scarce. According to Barclays' calculations, within the Bank of England’s legacy holdings, there are currently seven bonds maturing between 2029 and 2034, of which six have 30% to 50% of their outstanding balances held by the asset purchase facility. With limited prospects for new supply, the number of bonds available for trading or lending may further decrease over time, making these bonds relatively more expensive in the repo market and increasing demand.

Some longer-maturity government bonds held by the asset purchase facility may become candidates for the DMO’s auction program. This plan aims to alleviate market imbalances by selling non-benchmark bonds and taking advantage of lower yields. Moyeen Islam stated that this new system still has some “details” to be addressed, including how the DMO will handle the UK government bonds it receives. He stated that minutes from the September meeting “implicitly referred to the Monetary Policy Committee (MPC) discussing the DMO’s ability to ‘cancel bonds’, but such actions would need to be agreed with the market before being implemented.”