There has been a lot of debate on what will happen when the quantitative easing (QE) programme ends and the Bank of England (BoE) starts to reverse the liquidity programme.

One of the worries aired is that the sudden dumping of a large amount of Gilts onto the markets will cause their yields to jump significantly throwing the whole Gilt market into disarray. Even if the markets had factored this in when the BoE bought them off of the banks.

I am assuming though that this scenario will have been thought through right at the start, and the lack of evidence of communication between the Treasury and BoE on this goes toward confirming (to me) my suspicions.

Normally the government issues Gilts to raise money when banks (amongst others) buy them. The government owes the banks the money and pays them a coupon (interest) for the money they have borrowed from the banks. The Gilts can be bought and sold on the markets and the price varies (prices fall, yields rise or prices rise, yields fall). The Gilts (mostly) have a maturity date and on that date the government gives the money (the face value) back to whoever owns the Gilts. (For some more ln how bonds and gilts work see here)

I do not know if this is how they’ve done it but were I the BoE I would have bought Gilts from the banks with varying, but importantly balanced, maturity dates between short and medium term. Whilst holding them the BoE will be receiving the coupon (interest payments) from the government. That money will trickle into the BoE and be sent to the QE room to be un-generated cash (ie un-QE’d) and ‘disposed of’.

Now as to the Gilts themselves, I would not sell them, I would hold them to maturity and when they are redeemed the cash will come from the Government to the BoE QE room to also be un-QE’d.

The government will of course want to replace that borrowing so will issue Gilts into the normal market, but over a series of years, which will soak up the remaining liquidity. The pre-QE ratio of gilts in the economy will be (almost) restored.

This will mean that there will be no ‘Gilt-shock’ and will allow time for the markets to adapt gradually (maybe over a decade or so). Also, why would the BoE want to sell into a turbulent market when they already know what they have bought in the form of fixed interest instruments?

I imagine this will not be a zero sum game though. But it may, as they say, ‘be close enough for government work’.

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