MNI INTERVIEW: Lower Long Gilt Demand Risks Volatility - Miles

Fading demand from the pension sector for longer-dated gilts risks fueling volatility in UK borrowing costs and the Bank of England could re-consider its sales of such bonds, a member of the Office for Budget Responsibility's steering committee and former BOE Monetary Policy Committee member told MNI.

Lower structural demand for bonds is likely to make borrowing costs less predictable, David Miles said in an interview, after the OBR’s fiscal risks and sustainability report predicted that gilt holdings by defined benefit pension schemes, which were heavy gilt investors but are much less common nowadays, would fall from 26.7% of GDP in 2024-25 to just 5.6% in the early 2070s, potentially adding 75-80 basis points to the average cost of UK government debt.

The market curve may only partly reflect this fading long term demand, Miles said.

"I doubt whether all of it is factored in, partly because this is a process that's going to play out over a long period of time" he said.

"The Debt Management Office has gradually been skewing issuance a bit more to mediums and shorts and less to longs and ... index linked bonds. So I think this trend is likely to continue ... as the maturity of the stock of UK government bonds continues to decline, the significance of what happens at the shorter end of the yield curve, in terms of the cost of government debt, becomes greater.” (See MNI INTERVIEW: UK Borrowing For Investment Risky - OBR's Miles)

This shift to lower maturities brings other risks, with the government more exposed to sudden yield spikes, which feed through more quickly when maturities are lower, he noted. 

“A significant shortening of the maturity of government debt does pose some issues," Miles said.

BOE FACES QT SALES CHALLENGE

The BOE, which has been selling gilts back to the market along the curve, is facing calls from market participants to scale back longer-dated sales.

"I don't think the Bank of England is trying to predict where the yield curve is going, but nonetheless, if you get what could turn out to be a temporary spike at the very long end, it doesn't look the best time to be selling the long-dated bonds. Why not wait and see? It's not as if the Bank faces an urgent need to sell off the gilts in some short period of time," Miles said.

One positive factor for both the government and for the BOE’s attempts to reduce the size of its balance sheet is that the central bank’s new demand-led reserves system based on repos will incentivise commercial banks to buy gilts to use as collateral. (See MNI INTERVIEW: BOE Urges Signups For Non-Bank Gilt Facility)

"As long as the banking system wants to hold a lot of reserves, and all the evidence is that the banking system is certainly not going to be comfortable going back to the position we were in before the financial crisis when the reserves were tiny, then commercial banks will be natural buyers," Miles said.

PRODUCTIVITY

The OBR has been criticised for being over-optimistic in its expectations for productivity growth, which are at the top of the range for forecasts. Miles said it will revisit its estimates this summer, and highlighted problems posed by the unreliability of UK labour market data. (See MNI INTERVIEW:  OBR's Productivity Outlook Realistic - Miles)

"It's still hard enough to stare into the future and think what might happen to productivity, which is a pretty volatile series anyway. But it's much more difficult because the Labour Force Survey ... has become increasingly unreliable, because the number of people who were filling in the surveys on which this is based have just fallen so much," he said.

"The first estimates of productivity growth over some recent period might be that it was zero or even slightly negative, and in two years’ time you get the final estimates, it might actually be that it was 2% growth in that year ... It's difficult enough to know where you start from, let alone what's coming next.”