Gilt shortage: It takes two to tango

Yesterday’s failure by the Bank of England fully cover its bond purchase order indicates that the re-introduction of QE has created a significant squeeze in the UK’s bond market. This auction failure highlights a possible constraint on the BOE’s QE policy, at least until a more expansive fiscal policy delivers a significant increase in the future supply of gilts or substitute securities.

The BOE’s re-introduction of QE on August 4th has been remarkably well received by markets. This was in our view less to do with the prompt re-introduction of QE and may be more closely linked to the clarification that negative interest policy (NIRP) has, for now at least, been ruled out as a policy tool.

Ruling out negative interest policy has several benefits. First and most significant, the economic benefits of NIRP remain uncertain. Second, ruling out NIRP will ease fears of declines in bank sector profitability and the resulting pressure on bank equity values. Third, the only remaining policy lever is now QE. Provided inflation expectations remain relatively well contained, market participants will form expectations that incremental shortfalls in growth relative to forecasts will be met with more QE, thus stabilising asset prices.

As comforting as this may sound, there are some technical caveats. There have to be sufficient assets for the BOE to buy to maintain a credible position of being able to continue or expand the QE program for as long as is necessary to support economic growth. However, given the current uncertainty, the private sector seems unlikely to significantly increase the supply of QE-eligible assets such as corporate bonds or bank loans eligible for securitization, even as yields fall. The apparent shortage of gilts is therefore something of a concern.

We fear the new-found confidence in domestically-focused UK equities is at risk of proving unsustainable unless there is a meaningful expansion of fiscal policy later in the year (and this is also a long time for markets to wait). An expansionary fiscal policy could both support profits growth by providing profitable opportunities in providing services to the government sector and also enable the BOE to credibly assert that its QE program can be expanded and remain in place for as long as necessary.

The equity market seems therefore to be taking Chancellor Philip Hammond at his word that there will be a “reset” of fiscal policy in November’s autumn statement, even as current yields in the bond market indicate some doubt. Such a fiscal reset, involving for example a fiscal stimulus of 2% of UK GDP, would largely offset the increase in gilt demand from the BOE’s QE program, taking account of the widening of the budget deficit that should be expected as the economy slows.

Provided there is a credible fiscal plan, the UK’s resulting net debt position would by no means become exceptional in the context of other developed nations. Furthermore, as long as the BOE was willing to purchase and hold government debt, Japan’s experience suggests that a surge in government borrowing costs would be unlikely in such circumstances.

However, even if some kind of fiscal stimulus is taken as the base case, this seems fully discounted by UK mid-caps which are once again trading at very high price/sales multiples compared to their history.

Quick conclusions

1. The failure of the BOE’s bond buying auction yesterday highlights the squeeze on long-dated UK government bonds.

2. Clarifying that NIRP is not an option for the BOE has buoyed markets by easing pressure on banks and highlighting QE as the BOE’s only policy option.

3. For the rally in domestically focused mid-caps to be sustained, a significant “reset” in UK fiscal policy may be needed to give the BOE room to continue with unimpeded QE – and also to support profits growth in the UK corporate sector.