At its November meeting the Bank of England decided to continue with its current quantitative easing (QE) programme, by 6 votes to 3. The Bank of England has long maintained that it is the stock and not the flow which is most important. Any decision to end QE early would, in the Bank’s view, have resulted in a tightening of financial conditions.
But with inflation at decade highs, labour markets doing better than expected post the unwinding of the furlough scheme, and financial markets ‘functioning’, what justification does the Bank have in continuing with its current programme, and could unintended consequences arise?
For much of the last 18 months bond markets have been calmed by the presence of Central banks. In the UK, the Bank’s huge QE programme has neutralised the impact of record gross gilt issuance on gilt yields. However, the flow dynamic changed when the November budget saw gilt issuance drastically cut for the rest of the fiscal year. With the Bank deciding to maintain its QE programme into the end of the year, demand for bonds now exceeds supply. The Bank is inadvertently sucking liquidity out of the market, increasing volatility, which in turn reduces liquidity further; a negative feedback loop has been created, at a time of year when liquidity is already tailing off. The distortions and volatility are there for all to see.
For active investors these distortions provide opportunities. However, could unintended consequences arise for the taxpayer. From April 2022 next year, the market will likely have to digest near record levels of supply without central bank support. The key question going forward is, will the distortions being created and experienced today, force investors to re-evaluate the premium they charge the Debt Management Office to bring new bonds to the market; both in terms of higher yields and higher new issue premiums. The short-term actions of the Bank could inadvertently cost the taxpayer next year.
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