BoE bond sales may be pushing up borrowing costs by more than thought, research shows

By Naomi Rovnick and Andy Bruce

LONDON (Reuters) -The Bank of England's unwinding of its vast stockpile of British government bonds has likely raised gilt yields by more than the central bank previously estimated, according to new research.

A study by University of Liverpool economist Costas Milas suggests that the BoE's quantitative tightening programme has raised the 10-year gilt yield by an average of 25 to 30 basis points, compared with a counterfactual where the BoE ran down its stock of gilts at half the pace.

That estimate rises to 31 to 34 basis points, based on the median findings of the study.

British 10-year bond yields are the highest among the Group of Seven advanced economies.

The study helps to explain at least a small chunk of that underperformance - a constraint for the borrowing plans of finance minister Rachel Reeves who is due to announce her annual budget on Wednesday.

An analysis published by the BoE in August pointed to a smaller impact. Staff at the central bank estimated the total increase in 10-year gilt rates from cumulative quantitative tightening to date of 15–25 basis points.

The BoE says the economic effects of QT are small but it is monitoring for signs this is changing.

Its stockpile of gilts peaked at 875 billion pounds ($1.15 trillion) during the COVID-19 pandemic as it sought to stimulate the economy. The bond-buying was funded by the creation of reserves held by commercial banks at the central bank on which the BoE pays its standard interest rate.

With interest rates much higher and bond prices lower than foreseen at the time of the purchases, the BoE's Asset Purchase Facility is now recording large losses - a hot political issue because the government is ultimately responsible for them.

Capital transfers from the government to the APF have averaged around 40 billion pounds for the last two financial years.

The BoE's move to shrink its holdings by actively selling gilts - something other central banks do not do - as well as letting them mature has brought some of those losses forward.

Milas' paper differed from the BoE's research as it modelled the impact of the size and path of the stock of asset purchases against counterfactual examples of a slower unwind - rather than measuring the impact of QT announcements and auctions held by the BoE.

Despite the larger estimate of the impact of QT on yields, Milas found that it had not been large enough to have forced policymakers to reduce interest rates as a result.

Earlier this month the BoE said wider benefits from its past government bond purchases mostly offset the large losses accruing on its bond purchase portfolio.

($1 = 0.7635 pounds)

(Reporting by Naomi Rovnick, writing by Andy Bruce, Editing by Alex Richardson)