Simply, QT is the process of winding down the government debt held by the Bank of England (BoE) – quantitative easing in reverse. QT can be achieved by the BoE not buying any more bonds when the ones on its books mature and/or selling the bonds it currently holds to investors (more on this, later).   

Why might this incur a cost? First, there’s a cost of carry, which is the interest (equivalent to Bank Rate) that the Bank pays on the reserves it created to buy the bonds during quantitative easing, minus the coupon that it earns on the bonds that it holds in its portfolio. 

Second, there’s the loss in the value of the bonds, which is crystallised either when they’re redeemed at, or sold at, a lower price than their purchase value. 

These costs are unique to the UK for three important reasons.

1. The Treasury is on the hook for any losses incurred by the BoE. These are accounted for in the fiscal rules and limit discretionary spending headroom. In the last fiscal year, the Treasury transferred the BoE a total of £45bn, and the Office for Budget Responsibility (OBR) projects another £35bn is needed this year. 
2. The BoE actively sells bonds – something many other central banks don’t do. If, like the Fed or the European Central Bank (ECB), it were to wind down its holdings by only not reinvesting the proceeds from maturing bonds, the BoE’s portfolio would shrink too slowly because of the long average maturity of its holdings.
3. The cost of carry weighs heavier in the UK than it does elsewhere because of the way reserves are treated. While some other central banks adopt a tiered system, remunerating minimum required reserves at 0% and any excess reserves at standard rates, the Bank of England remunerates all reserves at the Bank Rate. 

Much of the cost of QT results from the way the programme and the fiscal rules were designed, but we see three ways to mitigate it. 

In this scenario, the BoE stops its active sales in September, mainly because we are closing in on what it has described the “preferred minimum range of reserves”. The BoE estimates the upper bound of this is around £500bn, and reserves are currently £760bn – the combination of a heavy gilt redemption profile in the 12 months from September coupled with the loans it has made to smaller companies maturing means that reserves should quickly fall within that range over the next year or so.

Of the total cost of QT last year, £23bn was the cost of carry and £21bn was from the loss in value of the bonds. While stopping active sales won’t eliminate the £21bn entirely, doing so would reduce it significantly.

Some savings could be made by changing how reserves are remunerated and tiered. The cost of carry of the QT portfolio in the last fiscal year was over £20bn, and we expect a similar figure this fiscal year if the Bank Rate evolves in line with our central scenario and active bond sales end in September.

But it’s impossible to eliminate this cost entirely. Some reserves still need to be remunerated at the Bank Rate or it ceases to become the rate at which monetary policy is transmitted. 

Governor Bailey has been public in his criticism of making such changes, deeming that changing the way reserves are remunerated as the responsibility of fiscal policy which brings with it unintended consequences. Chancellor Rachel Reeves has also recently stated that she has “no plans” to do this.

Given the government sets its own fiscal rules, it isn’t out of the question that they could be tweaked in the future, especially if limited fiscal headroom hampers the government’s discretionary policies. However, this kind of interference may be viewed unfavourably by the markets and lead to unintended consequences due to the market impact of locking in large losses on gilt sales.

After selling off towards the end of May, gilt yields soon hit our target levels for the end of Q2 (4.35% for 10-year gilts, although they have fallen back again since then). The increase was warranted, in our view, although the speed of the move was surprising.

Tellingly, it showed that when markets stop focusing on the monetary policy cycle, fiscal policy can again become the main driver of market moves. In our view, that means yields are likely to continue increasing and curves steepening in the short term. That’s not least because there’s set to be heavy net gilt supply over the coming months. 

Another issue is headline political risk in the near term. While the sizeable Labour majority should increase political stability, it may keep some overseas investors on the sidelines for the time being. That could be problematic as they have played a key role in supporting the gilt market in recent times. 

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