U.K. Rate-Hike Bets Turn Focus to BOE Balance Sheet Unwind

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The Bank of England’s plan to wind down its balance sheet is coming into sharper focus as investors ramp up their rate-hike wagers, a move that would reverse the support the gilt market has enjoyed for over a decade.

Traders are now betting the BOE will raise the key interest rate to 0.5% in February. That’s the threshold after which the bank may let gilts that mature in its 875-billion pound ($1.2 trillion) asset purchase program roll out of the portfolio without being replaced.

With inflationary pressures building and officials taking an increasingly hawkish tone, some investors expect that could happen as early as March, when a 28-billion pound gilt comes due.

It’s a daunting prospect for a market already grappling with the end of the BOE’s bond-buying program, slated for December. Since 2009, in the wake of the financial crisis, the central bank has bought around one-third of the total stock of government debt, according to the Office for Budget Responsibility.

“We didn’t really think it would be a story the market would focus on for some time,” said James Lynch at Aegon Asset Management. “What was a tail risk event of the March bond not being reinvested is now looking like a base case.”

The pace of the repricing has been staggering. In just four weeks, the market pulled forward expectations for when the BOE’s key interest rate would hit 0.5% by nine months, egged on by policy makers including Andrew Bailey who said over the weekend that the bank would “have to act” to curb inflationary forces.

‘Different Dynamic’

To be sure, it’s still not clear when the BOE will start hiking. And strategists are divided over how policy makers would even respond when the key rate reaches the threshold set out in their August monetary policy report.

In theory though, the bank could allow for as much as 37 billion pounds of government debt to roll off its balance sheet by the end of 2022, according to Bloomberg calculations and Bank of England data.

If the key rate reaches 0.5% there is “definitely going to be a different dynamic for the next year,” said Craig Inches, head of rates and cash at Royal London Asset Management. “You’re going to have a situation where auctions are coming thick and fast to the market. And the market needs to digest that,” he said.

It adds to a complex picture for traders weighing the risk that tighter policy begins to undermine the U.K.’s fragile economic recovery.

The outlook for growth next year was trimmed by 0.4 percentage points to 5.1%, the sharpest reduction for any major European economy, according to a monthly survey by Bloomberg published Monday.

‘Hawkish Step’

“I think stopping reinvesting in March is very bold step, a very hawkish step. And I think it will have very negative implications for the market,” said Theo Chapsalis, the head of U.K. rates strategy at NatWest Markets Plc. He says the move could prompt a 15-to-20 basis points sell-off in gilts across the curve.

Analysts at Goldman Sachs Group Inc. are taking a more sanguine view. They expect the BOE will halt reinvestments after the February meeting, arguing that policy makers expect there to be “very limited impact on financial conditions.”

RBC Europe Ltd. said the BOE could pause on rate hikes after this step, given the “uncertainties” over the tightening impact. Meanwhile, Bank of America Corp. said the BOE would most likely choose to reinvest around half of the proceeds of the bond coming due in March — to prevent overly “aggressive” tightening.

For others, the exact timing is less important than what it signals. The market now sees the rate rising to 1% by around the middle of next year, the threshold at which the BOE said it would consider selling the gilts it owns directly.

“We have to price in some chance that in a few months, they’re actually selling these bonds. That’s a bigger deal,” said Andy Chaytor, a desk strategist at Nomura International Plc.

For now, the next hurdle is BOE’s monetary policy meeting on Nov. 4. Traders are wagering that it could make its first rate hike at this meeting, with close to 20 basis points priced in.

Meanwhile, any sign that there’s still slack in the labor market could be enough to derail the market’s view on the path for interest rates.

“I think you probably want to be quite nimble going into that meeting,” said Lynch at Aegon Asset Management.

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