U.K.'s first negative-yielding bond sharpens focus on BOE

Britain sold bonds with an average yield below zero for the first time, intensifying a debate on negative rates hours before testimony from the head of the Bank of England.

The U.K. Debt Management Office raised £3.75 billion ($4.6 billion) by tapping existing bonds maturing in 2023. While the yield at -0.003% is little surprise to market watchers — given that the existing bonds were already trading at roughly the same level — what makes the auction precarious is the timing.

That's because if Gov. Andrew Bailey repeats his opposition to negative interest rates during testimony Wednesday before Parliament's Treasury Select Committee, buyers could see the value of their gilt holdings plummet.

"If he was overtly hawkish, yields on short gilts would be likely to rise," said John Wraith, head of U.K. and European rates strategy at UBS Group. "But I suspect whatever he says will be aimed at reassuring the market and wider public that the BOE stands ready to do anything and everything it thinks could help if the economic situation worsens."

Gilts have rallied this week after BOE policymakers Andy Haldane and Silvana Tenreyro raised the prospect of further easing, with Brexit fears and the coronavirus lockdown pushing Britain toward its worst recession in three centuries. Yet Mr. Bailey has pushed back against negative rates, saying last week that although nothing should be ruled out forever, they were not under consideration.

In March, the BOE announced it would add £200 billion of gilts and corporate bonds to its asset-purchasing program, expanding it by 45%. Barclays, which sees negative rates as the last policy tool the BOE would choose, expects a further £100 billion of quantitative easing in June.

Adding fuel to the fire, U.K. inflation in April fell to the lowest since 2016 amid a drop in energy prices and an economic slowdown induced by the lockdown.

"This morning's release of the U.K. CPI inflation data shows that price pressures are way below where the Bank of England would like them to be," said Jane Foley, a strategist at Rabobank. "This adds interest into the debate about negative interest rates."

While the nation's economic outlook is bleak, the sale highlights that the government's huge spending plan to support the U.K. hasn't spooked investors. That's largely thanks to the BOE's asset-purchase scheme, which has kept the cost of borrowing close to historically low levels.

It's one reason why demand outstripped the amount of bonds on offer more than twofold. Even though existing bonds due July 2023 saw their yield fall more than 60 basis points this year to zero, Citigroup strategists including Jamie Searle say the issue looked cheap compared to peers with similar maturities.

"If anything, this also shows that despite the additional gilt issuance, there is still a structural shortage," said Antoine Bouvet, senior rates strategist at ING Groep.

On Tuesday, investors piled into the U.K.'s syndicated bond sale, with orders for the £7 billion offering exceeding £53 billion.

Overnight interest-rate swaps are pricing in subzero rates by December's BOE meeting, yet are only just below zero. The contracts fall progressively lower through 2021, reflecting caution in the market about how to interpret the BOE's messaging, concern about the consequences of lifting the lockdown too soon and the risk of a messy divorce from the European Union.

Sterling traders are also watching Mr. Bailey for clues. The price of insuring against a swing in the pound against the dollar overnight is hovering near regular highs seen since early April, as traders position for turbulence after he speaks.

"I can't think of an economy where negative rates are a worse idea than the U.K.," Kit Juckes, a strategist at Societe Generale, wrote in an emailed note. "How on earth does it make sense to even consider adding negative rates to the mix? The economic benefits are dubious but the power of a cocktail of negative rates and massive QE to weaken the currency seems clear."