July 9, 2009 / 6:29 PM / in 8 years

Gilt yields rocket as Bank keeps QE target unchanged

LONDON (Reuters) - Government bonds tumbled on Thursday, propelling 10-year yields almost a fifth of a point higher after the Bank of England announced no increase to its quantitative easing programme.

With the economy still reeling after its sharpest contraction in more than 50 years, markets had widely expected the central bank to increase its asset purchases by 25 billion pounds.

Traders fretted that its decision to leave the target unchanged meant the Bank's unprecedented scheme to buy assets, over 90 percent of which have been gilts, may soon be brought to an end.

Ian Kernohan, an economist at Royal London Asset Management, said the knee-jerk rise in gilt yields gave some indication of the size of the QE premium in gilt prices.

"The problem will be how to exit the QE strategy without causing a significant back up in yields and the cost of funding the government's deficit," he said.

The September gilt future settled 1.45 points lower, sharply underperforming the equivalent Bund future which fell just 24 ticks.

The belly of the curve, where most of the central bank's purchases have been focussed, suffered the most.

The yield on 10-year gilts leapt 18 basis points to 3.80 percent while the two-year gilt yield rose 10 basis points to 1.19 percent.

The yield spread between 10-year gilts and Bunds widened by 17 basis points to 49 basis points, its highest in four months.

The Bank said it would review the scale of its quantitative easing programme in August, when it publishes updated quarterly forecasts.

Some analysts saw this as a hint an extension to the programme had merely been delayed until next month, when it will be able to explain its actions more fully.

"This probably does not sound the death knell for QE," said Philip Shaw, chief economist at Investec. "Rather we expect an increase next month, when the monetary policy committee will have the benefit of a fresh set of inflation projections," he added. The Bank indicated that it would slow the pace of its gilt purchases, buying just 4.5 billion pounds of gilts next week. Since April, the central bank has been buying gilts at a rate of 6.5 billion pounds a week - roughly double the rate at which the government has been issuing them.

It also announced that it would exclude the 4.75 percent 2020 gilt from its forthcoming purchases causing the yield on the bond to jump almost 20 basis points on the day.

The Bank had recently started to exclude gilts in which it owns more than 70 percent of the free float and which trade richly on the curve.

Reporting by Christina Fincher

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