Borrowing costs fall after Bank of England ‘surprises’ markets with bond sale change

Government borrowing costs dipped on Thursday after the Bank of England elected to maintain interest rates and terminate its extensive bond sale program. This adjustment to the bond sale structure led to a decline in yields on both short-term and long-term government bonds, as traders adjusted their forecasts for monetary tightening and factored in the reduced supply of gilts entering the marketplace.

The two-year gilt's borrowing cost dropped by eight basis points - nearly a tenth of a percentage point - bringing it back to pre-selloff levels after a significant sell-off over the past ten days. The 10-year gilt, serving as the benchmark for long-term government borrowing, also saw a rate decline of nine basis points during the Thursday trading session.

In accordance with expectations, the Bank of England's Monetary Policy Committee decided to keep its base rate steady at 3.75 percent, despite warning that inflation was likely to surpass four percent by the year's end. Six committee members opted to maintain the current Bank Rate, while three, including chief economist Huw Pill, advocated for a 25 basis point increase.

Despite some analysts predicting that deputy governor Claire Lombardelli would join the dissenters, the vote remained consistent with the bank's stance in July, leading to a rally in UK shorter-term bonds.

The Bank rate-setters attributed the shift to evidence of "second-round effects," whereby sudden price increases from supply shocks eventually impact the broader economy, yet had yet to be reflected in the official data despite recent tensions in the Iran conflict. Governor Andrew Bailey noted a "material increase in energy prices since July," which in turn affected the near-term inflation outlook.

He also cautioned that if the Middle East conflict persists and the risk of second-round effects grows, policy tightening might be necessary.

The most significant borrowing cost movements were observed in the longer-dated bonds, which the government repays over extended periods - often decades. The yield on the 30-year bond experienced a drop of up to 12 basis points, reaching levels not seen this century, following the Bank of England's announcement to halt its sales of all long-term debt.

Alongside the interest rate decision, Bank officials unveiled a significant overhaul to how it manages the unwinding of the £billions of bonds it purchased since the 2008 financial crisis. This proposal involves selling gilts directly to the Treasury rather than through the open market, and ending all planned sales of long-term debt, retaining them on its balance sheet until maturity.

Modupe Adegbembo, an economist at Jefferies, remarked that while halting active long-end sales was not unexpected, pausing sales entirely and opening the door to an alternative sales model did come as a surprise to markets. He added that active sales were not the only factor contributing to long-end gilt underperformance, but reducing the likelihood of future sales eliminates an important pressure point on the sector.