By Mike Peacock
, (Reuters) – Bond vigilantism has returned to Britain, raising the prospect that the government will be forced to consider politically toxic tax rises or public spending cuts to placate investors concerned about the country’s fiscal health. But Chancellor of the Exchequer Rachel Reeves could also get a helping hand from the Bank of England’s balance sheet.
In the first weeks of 2025, certain gilt yields spiked to highs last seen in 2008. While yields have since come off these highs, following softer-than-expected December inflation data, it is fair to assume the UK bond market could be in for a bumpy ride in the coming months.
Recent market gyrations primarily reflect the global jump in government bond yields, driven by uncertainty about the potentially inflationary policies that U.S. President Donald Trump’s second term might bring.
But gilts have been buffeted around more than most, suggesting investors may have UK-specific concerns, namely that the new Labour government’s policies will increase debt without doing much to improve growth.
While all this has been happening, the BoE has continued with its ‘quantitative tightening’ (QT) program, selling gilts after years of being the major buyer of UK government bonds. Unlike the Federal Reserve, the BoE isn’t just letting debt roll off its balance sheet but is actively selling.
The gilt market is worth around 2.6 trillion pounds ($3.17 trillion), and at its peak, the bank held nearly 900 billion pounds of it. If the BoE’s current QE plans continue unchecked, that number will drop to roughly 560 billion pounds by the end of September.
The UK is expected to issue approximately 300 billion pounds worth of gilts this year and a similar amount in the following fiscal year. Meanwhile, the bank is planning to reduce its bond holdings by 100 billion pounds. The gilt market will thus have to absorb around 400 billion pounds over the next 12 months.
If the bank were to halt its sales, it would effectively cut supply by 25%, which would very likely put downward pressure on yields.
That would be welcome news for Reeves, who already faces annual debt interest payments of 105 billion pounds, a figure that will rise if government bond yields climb, eating into the resources she has available to boost the economy.
But given the BoE’s messaging, a complete halt is unlikely. What’s more probable is that the bank could decide to slow the pace of divestment, mimicking the Fed’s passive approach – i.e., not reinvesting as bonds mature.
Roughly 87 billion pounds of gilts will mature this year, so this strategy could reduce the bank’s gilt sales by around 13 billion pounds over the next 12 months.
There is a problem, however.
One reason recent bond market jitters did not reach the chaotic levels seen during the 2022 UK market meltdown presided over by former prime minister Liz Truss is that Reeves has been clear that she respects the independence of the central bank and the Office for Budget Responsibility. Truss explicitly wanted to rein them in.
Any hint that this independence is being infringed now could unnerve investors.
So if the BoE were to act, it would have to show markets that it was doing so to uphold its mandate – not because of political or fiscal concerns.
One potential justification would be market instability, as the BoE is tasked with ensuring markets function properly. BoE Deputy Governor Sarah Breeden said earlier this month that the bank was monitoring the market closely, but there was currently no cause for concern.
A second motive could be impaired monetary policy transmission. For example, if the BoE cuts official rates when it meets in early February yet market interest rates continue to rise, this would tighten monetary conditions when the bank wants the reverse.
Simon French, chief economist at Panmure Liberum, noted that a change in the QT program “wouldn’t be controversy free, with political accusations…and claims the bank is helping finance a fiscal overstretch. But it is the right thing to do for the UK economy”.
The BoE was accused of deliberately aiding the government when massive fiscal spending coincided with an increase in quantitative easing during the Covid-19 pandemic, allegations the bank pushed back hard against. The following cycle of sharp rate hikes doused that debate, at least temporarily.
Having committed to its pace of bond sales, the BoE won’t be eager to change tack. But if gilt market volatility intensifies, it may not have a choice.
(Mike Peacock is the former head of communications at the Bank of England and a former senior editor at Reuters.)
($1 = 0.8195 pounds)