Bank of England prepares for crucial QE test
All eyes will be on Threadneedle Street tomorrow afternoon as the Bank of England gears up for its next bond-buying mission.
To the market's surprise, the Bank of England could not find enough willing sellers of long-term government debt on the open market last week, leading to the first ever time when the Bank was unable to buy as many bonds as it wanted.
The £52m miss – about four per cent of the £1.17bn it wanted to buy – rattled markets, and caused bond yields to come tumbling down to fresh record lows. Tomorrow, the Bank will try again, with analysts expecting it to be a slightly smoother affair. The three other auctions that have taken place so far – for short and medium-term bonds – have gone ahead without incident.
"Given the market’s and media’s focus on the earlier reverse auction failure, there is probably a low probability of failure tomorrow," said Shilen Shah a bond strategist at Investec. He was one of many to suggest a combination of low summer trading volumes and a general wait-and-see approach from market makers caused last week's shock miss.
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Jeremy Cook, chief economist at World First said: "Bond markets over 15 years can be quite illiquid at the best of times so a reverse auction in August will have exacerbated this issue."
Nick Gartside at JP Morgan said he believed last week's failure was simply down to markets not quite remembering how the mechanics of quantitative easing works. "It was the start of the programme, people had to get back into 'QE mode' and of course it’s a very quiet time of year."
The Bank of England will try to buy another £1.17bn worth of government bonds with a shelf life of more than 15 years tomorrow – and every week for the next six months. These are understood to be some of the trickiest to buy, since they are typically held by the likes of pension funds, who have little interest in selling them, and then trying to find somewhere else to stick their cash with a half-decent return.
Nevertheless, now the Bank has fallen short once, the prospect of a second failure is being discussed with more more regularity.
"The Bank may struggle to mop up the longer-term gilts they crave," said Neil Williams, group chief economist at Hermes. "With global rates low or negative, the queue for yield was building long before the Bank rejoined it last week."
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"It could happen again," added Mark Capleton, head of UK rates strategy at Bank of American Merill Lynch. However, Capleton believes now market makers have had a warm up, they will be much more likely to put in speculative bids, asking the Bank to pay up considerably more than the market rate. He recommends looking at the different prices Threadneedle Street has to pay to secure government debt to see how successful the auctions are, rather than just whether it finds enough sellers.
What would another failure mean for the Bank? Would it have to shift strategy, or could it dust it off and plough through?
"You can probably get away with one [failure]," Jason Simpson, UK rates strategist at Societe Generale, told City PM "But if it starts happening regularly, it's a bit difficult to know what the Bank could do."
World First's Cook said while it would not be "particularly embarrassing" for the Bank, another failure "may raise questions about wether it needs to amend the buying plan."
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Mark Carney has pledged to buy around £3.5bn worth of government debt a week in regular auctions taking place on Mondays, Tuesdays and Wednesdays. The programme, which is set to last six months, will add £60bn to the Bank's balance sheet and take its total stock of government debt to £435bn.
Characteristically, the Bank stayed calm during last week's frenzied reaction to the failure. It has pledged to make up the shortfall in the second half of the bond-buying programme, which kicks off in November. With more than £200bn of long-term bonds eligible to be bought by the bank, the target of £1.17bn a week "is not a tall order by any stretch of the imagination," said Societe Generale's Simpson.
While it isn't expecting a failure, the Bank has the mechanisms in place, just in case.