Quantitative Tightening Won’t Fix Britain’s Economic Weaknesses

Bank of England QT Adjustments Eyed as Gilt yields Hit 25-Year Highs, US Treasury Auctions Signal Weak Demand

LONDON – The Bank of England (BoE) is increasingly likely to adjust its quantitative tightening (QT) program to ease upward pressure on long-dated gilt yields, currently near record highs not seen as 1998, according to a new analysis from ING. Though, the report cautions that any such adjustments will be a temporary fix, failing to address the underlying fiscal challenges facing the UK and broader global pressures on longer-term interest rates.

The ING report highlights a preference for allowing US-driven spillover effects to diminish on the shorter end of the sterling curve. More immediate attention, though, is focused on potential BoE moves to alleviate the strain on the long end. Options being considered include reducing the current £100 billion annual pace of QT or shortening the maturity of bonds being sold off.

“With plenty of liquidity still in the system,shortening the maturity of bonds being sold represents another avenue to address concerns,” the report states. “Though, the UK’s serious fiscal challenges and global upward pressure on longer rates mean these tweaks won’t resolve the structural issues facing Gilts.”

US Treasury Auction Weakness Adds to Concerns

Adding to the cautious outlook, the latest US 10-year Treasury auction revealed weaker-than-expected demand. Direct bidding from real money investors fell to below 20%, significantly lower than the 24% seen in the previous six months. Dealers were forced to absorb a larger portion of the offering, taking down 16% compared to a typical 10%. This marks the second consecutive “tailed” auction, following a similar outcome in the 3-year auction earlier this week, with the 30-year auction still to come.

The weak demand raises questions about appetite for yields at current levels,despite growing expectations of future interest rate cuts. ING analysts point out that the current 10-year Treasury yield of around 4.2% is effectively closer to 3.7% when factoring in the 50 basis point swap spread to SOFR. With 10-year SOFR currently at 3.7% and the market anticipating a funds rate bottom around 3%, the yield curve remains relatively flat.

“If wondering why not enough buyers at c.4.2% on the 10yr Treasury, that’s part of the answer,” the report concludes.

evergreen Insights: Understanding Quantitative Tightening & Gilt Dynamics

Quantitative Tightening (QT): QT is the reverse of quantitative easing (QE). QE involves a central bank injecting liquidity into the market by purchasing assets (like government bonds). QT reduces liquidity by allowing those assets to mature without reinvestment,or by actively selling them. The goal of QT is typically to curb inflation by tightening monetary conditions.
Gilt yields & UK Debt: Gilts are UK government bonds. Their yields are a key indicator of investor confidence in the UK economy and its ability to manage its debt. Rising gilt yields increase the cost of borrowing for the government and can impact mortgage rates and other lending costs.
Swap Spreads: The swap spread represents the difference between the fixed rate on an interest rate swap and the yield on a Treasury bond of comparable maturity. It can reflect market perceptions of credit risk, liquidity, and supply/demand dynamics.
Fiscal Challenges: A country’s fiscal health refers to its government’s financial situation, including its levels of debt and deficits.Persistent fiscal challenges can erode investor confidence and put upward pressure on bond yields.
* Global Rate Dynamics: Interest rate movements are increasingly interconnected globally. Factors like inflation, economic growth, and central bank policies in major economies (like the US) can significantly influence interest rates elsewhere.

How might the bank of England’s reliance on quantitative tightening impact business investment in the UK, given existing economic uncertainties?

The Limits of Monetary Policy in a Supply-Side Crisis

For over a decade, the Bank of England (BoE) has relied heavily on monetary policy – primarily quantitative easing (QE) – to stimulate the UK economy.Now,with inflation stubbornly high,the focus has shifted to quantitative tightening (QT),a process of reversing QE by selling government bonds. While superficially appealing as a tool to curb inflation, QT is unlikely to address the fundamental, supply-side weaknesses plaguing the British economy.It risks exacerbating the current downturn and hindering long-term growth.

Understanding the Core Problem: Supply, Not Just Demand

The current economic malaise isn’t primarily driven by excessive demand. Instead,it’s a complex interplay of factors restricting supply:

Brexit Impacts: The long-term effects of leaving the european Union continue to manifest in trade barriers,labor shortages,and reduced foreign investment. This impacts UK GDP and overall economic performance.

Global Supply Chain Disruptions: While easing,disruptions stemming from the pandemic and geopolitical events (like the war in Ukraine) still contribute to higher input costs for businesses.

Labor Market Participation: A notable portion of the UK workforce has left the labor market,driven by long-term sickness,early retirement,and skills mismatches. This creates labor shortages and wage pressures.

Declining Investment: Business investment has been sluggish for years,hampered by uncertainty and a lack of confidence in the UK’s economic outlook. This impacts economic growth and productivity.

QT attempts to cool demand,but it does little to resolve these underlying supply constraints. In fact, it could worsen them.

How Quantitative Tightening Works (and Why It’s Misapplied Now)

Quantitative tightening involves the BoE selling the government bonds it previously purchased during QE. This reduces the amount of money circulating in the economy, theoretically increasing interest rates and curbing spending. The intended effect is to lower inflation rates.

Though, in the current context:

1. Higher Borrowing Costs: QT pushes up government borrowing costs, potentially crowding out private investment. This is especially damaging when investment is already weak.
2. Increased Recession Risk: Aggressive QT can contribute to a sharper economic slowdown, increasing the risk of a recession. The UK economy is already teetering on the brink.
3. Limited Impact on Supply-side Inflation: Much of the current inflation is driven by supply-side factors. Reducing demand won’t magically increase energy production, resolve supply chain bottlenecks, or boost labor force participation.
4. Gilts Market Vulnerability: Rapid QT can destabilize the gilts market, as seen in the aftermath of the mini-budget in September 2022. This can lead to further financial instability.

The Case of Japan: A Cautionary Tale

Japan provides a compelling case study. For decades, the Bank of Japan (BoJ) has pursued ultra-loose monetary policy, including QE, without sustainably boosting inflation or economic growth. Japan’s struggles highlight the limitations of monetary policy in addressing structural economic problems. While the UK’s situation differs, the underlying principle remains: monetary policy is a blunt instrument that can’t fix deep-rooted issues.

What Would Work: A Focus on Supply-Side Reforms

Rather of relying on QT, the UK government should prioritize policies that address the underlying supply-side weaknesses:

Skills Development: Invest in education and training programs to address skills gaps and boost labor market participation. Focus on apprenticeships and retraining initiatives.

Infrastructure Investment: Improve infrastructure (transport, energy, digital) to enhance productivity and attract investment.

Regulatory Reform: Streamline regulations to reduce the burden on businesses and encourage investment.

Trade Agreements: Seek new trade agreements to diversify markets and reduce trade barriers. Addressing the impacts of Brexit is crucial.

Energy Security: Invest in renewable energy sources and improve energy efficiency to reduce reliance on volatile fossil fuel markets.

These measures, while politically challenging, are far more likely to deliver sustainable economic growth and lower inflation than QT.

the Role of fiscal Policy

Fiscal policy – government spending and taxation – also has a crucial role to play. Targeted fiscal support for businesses and households, coupled with strategic investment in supply-side reforms, can be more effective than QT in mitigating the economic downturn. A focus on government spending in key areas like green technologies and infrastructure could stimulate long-term growth.

Benefits of a Supply-Side Approach

A shift towards supply-side policies offers several benefits:

Sustainable Growth: Addresses the root causes of economic weakness, leading to more durable growth.

Increased Productivity: Boosts productivity, leading to higher wages and living standards.

Reduced Inflation: By increasing supply, it can help to alleviate inflationary pressures.

Enhanced Resilience: Makes the UK economy more resilient to future shocks.

Practical Tips for Businesses Navigating QT

While QT isn’t the solution, businesses need to prepare for its potential impacts:

Manage Debt: Reduce debt levels and secure fixed-rate financing where possible.

* Control Costs: