By Mike Dolan
LONDON, July 21 (Reuters) – It may not thrill bulled-up bond investors, but a halt to central bank interest rate rises this year could be accompanied by stepped-up reduction of balance sheets, or QT – preventing markets running away with “peak rate” hopes.
“Quantitative tightening” – reversal of the massive central bank asset purchases undertaken to support bond markets as the coronavirus hit in 2020 and during the banking crash 15 years ago – has been quietly humming in the background for the past year, largely drowned out by the din of steep official interest rate rises to tackle high inflation.
As disinflation deepens, however, central banks will find it harder to justify many more policy rate hikes in the current cycle – not least as the lagged effects of the past year’s campaign are still kicking in and the effects from here are now uncertain.
But in stopping the rate hikes they will have a hard job preventing investors from loading up further on bonds and driving down borrowing costs for the wider economy in the hope policy easing then follows – prematurely for many policymakers’ liking if inflation still exceeds their 2% targets.
Rhetorically at least, the Federal Reserve has already been fighting this battle as it potentially hits what markets assume will be its “terminal rate” next week – and has been stressing a “higher-for-longer” policy rate right to the end of next year.
But management of central bank balance sheets could help – even if central bankers are keen to publicly disassociate the process from monetary policy goals per se.
Having fully unwound a temporary pop back higher around March’s regional bank stress, the Fed’s $8.26 trillion balance sheet was back at its lowest level in two years as of July 13 – almost three quarters of a trillion below pandemic highs. At just over 20% of outstanding Treasuries, that share is back close to early 2020 levels – and also levels of eight years ago.
While Fed policymakers reckon there’s a high bar to tweaking the U.S. central bank’s current runoff rate of $95 billion per month, they also see it as a ‘backup’ to interest rate policy.
But the U.S. central bank can be more comfortable nearing peak rates with inflation much closer to target than Europe’s central banks – where future trade-offs may be more tempting.
BACKGROUND NOISE?
For one, Bank of England Deputy Governor Dave Ramsden on Wednesday advocated allowing a likely increase in the pace of government bonds running off the central bank’s remaining 800 billion pound ($1 trillion) balance sheet – which had at its height more than doubled during the pandemic – over the year from September.
That’s as markets now expect the BoE’s main interest rate to peak below 6% by December – relieved as they were by this week’s news that outlying UK inflation finally started to ebb back below 8% in June for the first time in a year.
It stands to reason that if the pain of even higher rates is hard for households and the wider economy to bear from here without seeding a deep recession, then an accelerated withdrawal of BoE support for the bond market may allow it to halt those hikes while keeping market conditions relatively tight.
Ramsden laced his comments with caution about not confusing the run-down of the BoE’s “asset purchase facility” with its central policy task. He also emphasised the pace of unwinding would be allowed to go up naturally by continuing to not re-invest maturing securities – as a bigger amount come due next year – and not require the BoE to increase active selling of bonds.
He also detailed in-depth BoE analysis that showed the 100 billion pounds of gilts and corporate bonds offloaded in the year through the third quarter of 2023 had only a small added tightening effect on bond pricing or liquidity – some 10 basis point or so – beyond the effects of steep policy rate rises.
But even while he stressed that the process should remain “gradual and predictable” and in the “background” – and with new repurchase facilities to guard against any related excess rundown of commercial bank reserves – it will surely help to rein in any untimely animal spirits in the bond market.
The BoE’s situation – indeed its haste to cut its balance sheet – may be complicated by its peculiar system of remunerating commercial bank reserves accumulated during bond purchases at its policy Bank Rate. Other central banks operate at different and variable reserve rates.
As the BoE jacks up policy rates, it also increases operating losses on a bond portfolio bought at far lower yields than its current policy rate – paying out more to the banks on reserves they’ve been credited with than the lower return it receives on bonds it bought from them in the first place.
The incentive for a speedy cut to the balance sheet…
Read More: COLUMN-Tightening on the QT :Mike Dolan