Investors cheer BoE move to pause gilt sales, driving bond rally

By Harry Robertson, Samuel Indyk and Yoruk Bahceli

LONDON, Sept 17 (Reuters) - British government bonds rallied sharply on Thursday after the Bank of England soothed the gilt market by announcing it would pause its active debt sales, which some commentators have blamed for adding to the pressure on gilts, as it held interest rates steady.

Yet investors said energy prices – driven by conflict in the Middle East – would continue to drive markets and could force central banks to hike rates multiple times, while the upcoming UK budget was also looming over gilts.

The BoE voted 6-3 to keep interest rates at 3.75%, in line with analysts' expectations. But it said inflation would likely top 4% next year and Governor Andrew Bailey warned prolonged conflict in the Middle East may require higher borrowing costs.

The focus for markets, however, was the BoE's long-term plan to offload its almost £500 billion ($670 billion) of bond holdings, which included a halt to sales until April and the end of sales of long-dated bonds entirely.

Gilts rallied after the announcement, particularly longer-dated securities which have been caught up in a global selloff that has pushed yields to multi-decade highs.

Britain’s 30-year bond yield was on track for its biggest daily fall since May at 12 basis points, to 5.74%, after earlier this week touching its highest since 1998 at 5.96%. Yields move inversely to prices.

"Reducing gilt sales and then abolishing them totally for the long-end is absolutely a positive," said Mohit Kumar, chief European economist at Jefferies.

"They have effectively changed the supply-demand picture, particularly for longer-dated gilts," he said. "That's why gilts are liking it."

The BoE has been the only major central bank to actively sell bonds as part of a widespread move to unwind crisis-era purchases.

Critics, including some British political parties, have said this has unnecessarily added to the pressure on gilts, though the BoE has estimated the impact has been small.

Benchmark 10-year yields dropped 8 bps while 2-year yields, which are more sensitive to interest rate expectations, fell 6 bps.

INVESTORS KEEP EYES ON INFLATION

The rally in bonds was aided by a drop in oil prices as reports of additional Saudi crude cargoes through Oman eased some supply concerns.

Evelyne Gomez-Liechti, multi-asset strategist at Mizuho, said energy prices would continue to largely dictate movements in bond markets.

"I think we have bigger factors at play – mainly the uncertainty around energy prices," she said. "The developments in the energy space, and whether that feeds into inflation, will ultimately dictate whether yields will move higher or not."

"I think it's a step in the right direction," Laura Cooper, head of macro credit at Nuveen, said of the pause to gilt sales.

Yet she added: "I think we need to see greater clarity on the fiscal front and the degree of what will come through in the budget for us to have conviction that some of that risk premium can start to fade in the long-term tenors."

New Prime Minister Andy Burnham and finance minister John Healey will present their first budget in October, with their room to manoeuvre limited by the recent rise in government borrowing costs.

Traders continued to fully price in a rate hike by the BoE this year, with a November increase seen as a 75% possibility and almost four 25-bp increases pencilled in by money markets by the end of 2027.

The BoE's decision came a day after the U.S. Federal Reserve hiked interest rates and a week after the European Central Bank raised borrowing costs for the second time this year.

The pound slipped slightly, while the FTSE 100 held on to earlier gains.

($1 = 0.7482 pounds)

(Reporting by Harry Robertson, Samuel Indyk and Yoruk Bahceli; Editing by Amanda Cooper)