Borrowing costs surge as Bank of England forges ahead with bond sale
Public borrowing costs have jumped to their highest level since 2011 as markets brace for a record flood of debt from £40bn of gilt sales by the Bank of England and Kwasi Kwarteng’s sweeping tax cuts.
Gilts suffered their worst day since the pandemic started after the Bank of England voted to raise interest rates by 0.5 percentage points and pressed ahead with plans to sell government bonds.
The pound also fell by 0.9pc against the dollar, dropping under $1.13 amid fears that the Bank had done too little to bring inflation down from 40-year highs.
The Bank will begin to reverse the bond-buying blitz – known as quantitative easing (QE) – that it launched to shore up the economy during the financial crisis and the Covid pandemic, by selling gilts from next month.
Its move will create a headache for Mr Kwarteng, the Chancellor, as he embarks on a borrowing binge with a raft of announcements on Friday. A cut to National Insurance, cancellation of corporation tax rises and a massive subsidy for energy bills are expected to drive up borrowing to £100bn a year according to the Institute for Fiscal Studies.
The Bank raised interest rates for a sixth time this year to a post-financial crisis high of 2.25pc, even as the rate-setters warned the UK economy is already in recession.
It came as GfK’s household confidence gauge crashed down to a new record low, revealing deep pessimism among consumers over their personal finances for the next 12 months.
The reversal of QE just as the Government ramps up bond issuance means investors will buy a record amount of UK sovereign debt next year, a glut that will push state borrowing costs even higher.
Rate-setters will reduce the Bank’s huge balance sheet of government bonds by a total of £80bn over the next 12 months, including £40bn through sales. It will begin selling the £857bn of debt left over from huge amounts of quantitative easing (QE) on October 3.
The 10-year gilt yield rocketed past 3.5pc for the first time since 2011 following the Bank’s meeting on Thursday as the UK was hit hardest in a global bond rout.
UK borrowing costs have risen faster than any other major country in the last month as market jitters over the new government’s more relaxed fiscal policy mount.
Some analysts had raised doubts over whether the Bank would push ahead with bond sales under quantitative tightening (QT) after the recent plunge in gilts fueled by fears of excessive borrowing.
However, the Bank has revealed that around half of the £80bn bonds will mature over the next 12 months and not be reinvested. About £40bn of gilts will be sold, including almost £9bn in the final three months of 2022.
Allan Monks, economist at JPMorgan, said: “There had been more uncertainty about this in light of significant and unanticipated new government issuance in the coming months. But ultimately the size of the sales at around £10bn per quarter was deemed small enough (by design) to minimise any potential conflict with the DMO [Debt Management Office].”
It will be the first sale of gilts built up by the Bank under quantitative easing (QE), the bond-buying blitz started in 2009 to prop up the economy. Threadneedle Street became a major buyer of government debt again when the pandemic struck.
ING economist James Smith said the fiscal bazooka fired by Ms Truss’s government and the bond sale “mean private investors will have to absorb a record amount of gilts”.
He said: “We understand the Bank's willingness to show that its balance sheet reduction plan won’t be scuppered by market volatility but we continue to argue that current gilt market conditions warrant greater attention.”
The Bank’s rate-setters unanimously voted to push ahead with the gilt sales despite highlighting the “sharp increase in government bond yields globally” and the faster rises in UK yields since the previous meeting.
The Bank also put more upward pressure on borrowing costs by pushing up interest rates by a further 0.5 percentage points to 2.25pc.
QE calmed UK bond markets when the pandemic struck by snapping up huge amounts of gilts. However, gilt yields have risen rapidly in recent months as the Bank increases interest rates and market jitters emerged over the UK’s fiscal policy under Ms Truss.
Stefan Koopman, strategist at Rabobank, said: “This leaves the British government in the peculiar situation of not having borrowed enough when global interest rates were low, and of borrowing a lot when global interest rates are high.”
Bailey bets that Truss’s energy bailout will save Britain from rocketing inflation
By Szu Ping Chan
Friday's mini-Budget marks the end of more than a decade of heavy economic lifting by the Bank of England, with Chancellor Kwasi Kwarteng instead taking up the baton.
In the years since the 2008 financial crisis, record low interest rates kept the economy supported while successive Governments pressed ahead with reforms.
But when the new Chancellor stands up Friday morning to unveil measures designed to break Britain's ‘cycle of stagnation”, the Bank will for the first time in years take a back seat when it comes to driving growth. Instead, the Government will be tasked with the job.
Threadneedle Street is rapidly raising rates in a bid to tame inflation, leaving Kwarteng to support the economy.
The handing off of the baton may be welcome. The UK is now facing two decades of stagnant real wage growth and a tax burden that's not been higher since the 1940s.
The Office for Budget Responsibility (OBR) believes the UK's long term growth rate is around 1.4pc. A new approach is needed.
In the short term at least, growth will be buttressed by the government's decision to cap average energy bills at £2,500 as energy prices continue to surge amid the war in Ukraine. This should give consumers more money to spend.
The energy market intervention means the government has also done some of Threadneedle Street's job for it. The Bank thinks Truss's decision to cap energy bills means inflation, as measured by the consumer prices index, will peak just below 11pc in October. It previously believed inflation would rise to 13.3pc next month.
Policymakers said government action would “limit significantly” further rises in inflation, with price rises also less volatile in the near term. Peak inflation is now expected to be around five percentage points lower than if no action was taken, the Bank said.
However, while the energy price guarantee should reduce the risk of high inflation leading to higher salary demands, the Bank signalled that interest rates may have to remain higher for longer because households had more money to spend. This adds to “inflationary pressures in the medium term”.
While the peak of inflation may have lowered, Threadneedle Street said it was likely to stay in double digits until the start of 2023.
“Energy bills will still go up and, combined with the indirect effect of higher energy costs, inflation is expected to remain above 10pc over the following few months, before starting to fall back,” it said.
The Bank has big calls to make in the coming months. Its prediction that the UK is in recession will also be put to the test as the Office for National Statistics (ONS) gets more information about how the economy has fared.
Unlike the Federal Reserve, where policymakers are singing from the same hymn sheet on the need to control price rises, the Bank is unsure about how much tightening is needed to keep inflation in check.
Five members, including governor Andrew Bailey, voted to raise rates by 0.5 percentage points to 2.25pc, while three others voted to tighten policy by 0.75 percentage points to reduce the risk of a “more extended and costly tightening cycle later” if people expected price rises to persist.
Swati Dhingra – a Rishi Sunak appointee who joined the MPC in August – voted to raise interest rates by 0.25 percentage points, citing signs of weakening economic activity that suggested fewer people would ask for big pay rises amid the greater economic uncertainty.
The uncertainty puts more downward pressure on the pound in a world where other central banks have decided that shock and awe is the best way to get the message across that they mean business. The US, Switzerland, Sweden and even the eurozone have all delivered bigger rate rises than the UK.
The Bank’s indecision piles more pressure on the Government to get it right on growth.
The Monetary Policy Committee (MPC) said the Chancellor’s multi-billion pound package of tax cuts, set to be announced on Friday, would alter the economic outlook in a “material” way.
It is expected to boost growth but add billions of pounds to public borrowing. The Bank's final verdict won't be delivered until November, when it publishes its next set of economic forecasts.
The Chancellor wants to lay the foundations for long-term growth, rather than a short-term sugar-rush of economic growth.
“For too long we have focused on how to split up the size of the pie rather than how to grow the pie,” said a Treasury insider.
In one sense, Kwarteng is right. The UK has never got back to pre-crisis growth rates. Many have tried, but failed to raise productivity, which is what really matters for living standards.
Productivity – which measures output per hour worked – tells us how much the economy can grow without generating too much inflation. When productivity grows, so do company profits and staff wages. This leads to stronger growth, a bigger economy, rising tax revenues and smaller borrowing bills.
Easier said than done, however.
Liz Truss's predecessor Boris Johnson vowed to return the UK to a “high-wage, high-skill, high productivity and low tax economy”. Osborne claimed his policies would “move Britain from a high tax, high welfare, low wage economy, to a lower tax, lower welfare, higher wage society”.
Johnson's predecessor Theresa May also vowed to improve living standards for who she described as the “just about managing”.
The words are familiar. But all tried, and all failed to make a material difference to living standards. Now, with the Bank of England pulling in a different direction to the Government, the challenge looks even more daunting.
Ellie Henderson, an economist at Investec, said: “The real question, and the bigger communications challenge, will arise at November’s meeting, when the committee will have the full details of the fiscal package and the opportunity to reflect their impact in its economic projections. How the MPC will navigate tightening in such an environment, when conditions may push it to a diverging policy path with the government, is yet to be seen.”