UK government finances are sensitive to rate rises. Why?

In its recent Fiscal Risks and Sustainability report the UK’s Office for Budget Responsibility (OBR) stated that “the rise in global interest rates has fed through to the UK’s debt servicing costs more than twice as fast as in the past or elsewhere”.¹

That statement led quite a few people to my desk, asking questions along the lines of “How is that possible? Doesn’t the UK have one of the longest average government debt maturities in the world? What happened?”

In short, what happened was quantitative easing (QE).

Switching it up

Since the start of QE in 2009, the Bank of England (BoE) has bought £875² billion of gilts through the Asset Purchase Facility (APF). This is equal to around a third of the UK’s public liabilities.³

The effect of QE on government finances has been to effectively switch long-term debt into floating-rate debt. This is because the government pays the bank rate on the reserves that have been created to buy the gilts in the APF, while it earns the coupons of the gilts in the facility. The average income from those coupons will be much lower than the 5% bank rate now.

Taking the effective maturity transformation of QE into account, the OBR report shows that the median maturity of the consolidated public sector liabilities has fallen from about seven years pre-financial crisis to two years by 2022. In other words, half of UK public sector liabilities would be impacted by a change in interest rates within just two years.

The other active/passive debate

Secondly, with QE, the BoE has bought gilts across the curve with an average maturity longer than that of other countries. As yields rise, losses on longer-dated bonds are larger. Even without quantitative tightening (QT), those losses are real, but with QT they’re also crystalised rapidly through capital losses rather than slowly through a net income shortfall.

When the bonds in the APF are sold or redeemed, the Treasury has to pay for the losses. While during ‘passive’ QT the bonds with low maturities/duration that are less sensitive to changes in interest rates are redeemed, during ‘active’ QT gilts across the curve are sold. Given the higher sensitivity of long-dated gilts to changes in interest rates, higher losses are crystallised in a rising rates environment.

From October 2022 to April 2023, £15 billion has been transferred from the Treasury to the APF to make up for the interest and valuation losses. The OBR estimates under March 2023 economic and fiscal outlook assumptions for bank rate and gilt yields, and for a constant £80 billion a year run-off of gilt assets, a cumulative net loss of £63 billion over the remaining life of the APF.⁴

Of course, this higher interest rate sensitivity of the public finances is symmetric. If the BoE were to lower interest rates in the future, that would flow through immediately to an improvement in the Treasury’s cashflows, mitigating those losses.

A pocket full of kryptonite

There are also some differences in the accounting treatment of QE in the UK compared with other countries. Losses are a lot more transparent in the UK. But putting those to one side, the country’s once-vaunted longer maturity profile bonds, which should have helped protect the UK through turbulent times, have become a pocket full of kryptonite.

Nonetheless, there might be a silver lining of sorts for the BoE. In the past, the main transmission mechanism of monetary policy has been through households and businesses. The higher sensitivity of government finances to interest rates might lead to fiscal tightening, if rates continue to rise, increasing the BoE’s ability to control inflation.

I’ll save the discussion about whether this is conceivable ahead of an election for another day.

1. Source: Fiscal risks and sustainability – July 2023 - Office for Budget Responsibility (obr.uk)

2. Source: https://www.bankofengland.co.uk/monetary-policy/quantitative-easing

3. Source: Fiscal risks and sustainability – July 2023 - Office for Budget Responsibility (obr.uk)

4. Source: https://obr.uk/docs/dlm_uploads/Fiscal_risks_and_sustainability_report_July_2023.pdf