UK rate-decision surprise ripples across global bond markets

The Bank of England holds fire on an interest-rate move, triggering the biggest UK bond-yield drop in years.

The Bank of England in London. ‘They’ve come out today and they’ve not acted and the bond market is moving aggressively.’ Picture: Getty Images

The Bank of England’s decision not to raise interest rates sent bond markets into a tizzy, leading to the biggest moves in UK bond yields in years.

The bank has said it expects to raise borrowing costs soon, moving ahead of the US Federal Reserve and other major central banks in withdrawing stimulus to tame inflation.

But the bank held fire on Thursday, surprising investors who had become convinced an increase was coming. Yields on one-year government bonds, known as gilts in the UK, nearly halved within hours, dropping 0.22 percentage point, in their biggest daily move since the 2009 financial crisis. The move also sent the pound down 1.4 per cent against the US dollar to $US1.349, its biggest one-day fall in more than a year.

The downdraft in yields rippled to other government-bond markets. Yields on US two-year Treasury notes slipped 0.07 percentage point to 0.41 per cent. German one-year government-bond yields fell 0.08 percentage point to negative 0.83 per cent, their biggest one-day drop since the coronavirus market panic of March 2020, according to FactSet.

“They’ve come out today and they’ve not acted and the bond market is moving aggressively,” said Ben Lord, a bond-fund manager at M&G Investments. He pointed to two sets of public comments from BOE governor Andrew Bailey in recent weeks that had convinced investors a move was imminent.

Mr Bailey and other senior officials pushed back against the idea they had sent a signal to expect an immediate change in policy. Mr Bailey said he was clear the need for tighter policy was closely linked to developments in the labour market and on inflation.

“It was a very close call,” he said at a news conference. “We are in a situation where the calls are close, they’re quite hard.”

Governor of the Bank of England Andrew Bailey addresses the Monetary Policy Report press conference on Thursday UK time. Picture: WPA Pool/Getty Images

The market surprise reflects the difficulty investors are having interpreting signals from central banks over how quickly they intend to act against inflation, which has been accelerating around the world thanks to a mix of brisk growth and bottlenecks in the global supply chain.

Those economic crosscurrents put central banks in a tricky position. Tighten too fast and they risk snuffing out recoveries. But if they move too slowly, inflation could intensify, squeezing households and businesses. The stakes for the global economy are heightened by the risk of further waves of Covid-19, with vaccination coverage patchy and winter approaching.

The Fed on Wednesday slowed the pace of its asset-purchase program and said it expects to wrap up the program in June. The European Central Bank has been more cautious, saying it doesn’t expect to increase borrowing costs before 2023.

Some smaller central banks have already begun tightening policy. The Bank of Canada last week announced a premature end to its bond-buying program, and the Reserve Bank of Australia this week abandoned an effort to pin down long-term interest rates. Central banks in Norway and New Zealand recently nudged up borrowing costs, and the Czech central bank on Thursday raised its key rate to 2.75 per cent from 1.5 per cent, a move that was much larger than expected.

Central banks broadly agree that the current burst of higher inflation will prove fleeting, and that price growth will fade as supply-chain kinks are worked out and the stimulus needed to support economies through the pandemic is reduced.

The BOE mostly stuck to that script, though officials voiced concern that a spell of higher inflation risks driving up expectations of future inflation, fuelling further cycles of wage and price growth.

Annual inflation is expected to peak at 4.8 per cent in the second quarter of 2022, more than twice the BOE’s 2 per cent goal, the central bank’s forecasts show. The British economy has periodically struggled with bursts of high inflation in the past, reflecting its dependence on imported food, energy and other commodities vulnerable to volatile swings in prices.

The nine-member panel wasn’t unanimous on the decision to hold rates, minutes of their deliberations showed. Two policy makers, David Ramsden and Michael Saunders, argued for an immediate rise in rates to counter the risk the BOE needs to tighten policy more abruptly later to bring inflation back to target.

The majority, including Mr Bailey, chose to keep the BOE’s benchmark rate at its current level of 0.1 per cent.

The panel was also split over continuing the asset-purchase program, underscoring the balance of risks around growth and inflation officials are grappling with. The BOE’s purchase of UK government bonds — which aims to keep long-term interest rates down — is due to end by the close of the year, but three members of the panel argued for stopping it right away.

New forecasts showed officials expect annual inflation will be close to 2 per cent in two years and below 2 per cent in three if interest rates are ratcheted higher, to around 1 per cent by the end of next year, as implied by prices in financial markets when the BOE concluded its forecasts. That suggests officials anticipate a slower and steadier path of rate increases than investors.

The BOE trimmed its growth forecast for the UK economy in 2021 to 7 per cent, from 7.25 per cent previously. That means it expects the economy will only regain its pre-pandemic size in the first quarter of 2022, rather than this year.

It expects supply-chain disruption and labour shortages to dog the UK throughout next year, pulling expected growth in 2022 to 5 per cent, from a forecast of 6 per cent previously.

In the lead-up to the BOE’s decision, some investors bet on a rate increase by selling U.K. government bonds, causing prices to drop and yields to rise. The UK’s benchmark 10-year bond yield fell to 0.982 per cent Thursday from 1.074 per cent Wednesday, according to Tradeweb. The fall put the benchmark 10-year bond yield under 1 per cent for the first time in a week.

With Paul Hannon

The Wall Street Journal