As expected, the Bank of England (BoE) kept the bank rate at 0.1%. The big surprise was the extent of further quantitative easing (QE) – its bond buying programme.
Instead of the £100bn we were expecting, the BoE has raised planned government bond purchases by £150bn; it plans to keep the pace of government bond purchases steady for now. By contrast, the stock of corporate bond purchases remains at £20bn, with the BoE not committing to any additional corporate bond buying.
To put this into some context: completion of the extended QE programme will take the stock of bonds bought by the BoE to £895bn, of which £875bn will be conventional gilts. At the present time, the size of the UK conventional gilt market is £1.8tn. This increased during the QE programme, reflecting the rapid rise towards a £400bn public spending deficit. In broad terms, the BoE is heading towards owning half of the conventional gilt market.
Why has the BoE extended QE by so much?
- It is concerned about the implications of a prolonged Covid crisis. The BoE now assumes a contraction of UK GDP in the fourth quarter
- It has changed its Brexit assumptions. The BoE now has a greater focus on potential economic disruption in the early part of 2021
- It now considers the risks around its GDP projection to be skewed towards the downside
Somewhat surprisingly, given the lower economic projections, inflation is expected to be 2% in two years’ time in the Bank’s central projection, as the impact of spare capacity on inflation will be a little less than expected.
What are the implications for sterling bond markets?
- It is likely that planned QE will be followed by further expansion. However, the £150bn (plus an additional £40bn reinvestment) will likely absorb the vast majority of next year’s gilt issuance
- As a result, gilt yields are likely to stay low over the medium term, barring a silver bullet in the form of a vaccine
- Long gilt yields will remain suppressed over the medium term, but over the longer term the gilt curve could steepen as the impact of QE weakens and the market mulls more fiscal stimulus and vaccines
- Negative rates are still an option – and the market-implied expectation – but not the Bank’s preferred route
- Sterling investment grade (IG) bonds:
- The BoE owns less than 3% of the sterling IG market, which is a different scale to its gilt ownership
- Credit spreads, at 1.2% over gilt yields, have retraced most of their widening in 2020 and we see little scope for further yield compression
- Spreads will remain at lower levels because of the impact / search for yield as a result of overall QE
- Pricing differentials that have arisen from the BoE’s recent corporate bond buying programme will erode
- Short-dated credit bonds look much better value than government debt and are more attractive than long-dated credit, given the expectation of yield curve steepening over the longer term
- Inflation-linked bonds, while not part of QE buying, will remain supported by economic and market conditions (i.e. indirect QE impact)
- Unlike other markets, implied inflation (i.e. conventional minus real yields) in the UK has remained high; we see better value in other markets
- RPI reform will need to be addressed soon, which may create uncertainty
- Longer-dated real yields remain extremely low by any historical measure
Past performance is not a reliable indicator of future results. The views expressed are the author’s own and do not constitute investment advice.