Second BoE rate rise sounds 'QT' klaxon :Mike Dolan

LONDON, Jan 28 (Reuters) - The great unwinding of bloated central bank balance sheets could start as soon as next week.

While investors have been in thrall to the U.S. Federal Reserve's hawkish anti-inflation twist in 2022, the Bank of England is widely expected to hike UK interest rates for the second time in less than three months next Thursday and double its main policy rate to 0.5% in the process.

In August, the Bank announced it would start reducing its balance sheet once base rates hit 0.5% - much lower than the 1.5% threshold it had flagged previously.

Unlike other central banks, there's more pressure on the Bank of England to run down its balance sheet once rates rise because its main policy rate is the very rate it pays commercial banks for the central bank reserves created via bond buying.

The resulting maturity mismatches on BoE assets and liabilities means sharply rising interest rates and a flattening yield curve could see the BoE incur losses the Treasury ultimately has to cover.

The government's budget watchdog - the Office for Budget Responsibility - estimates that a percentage point increase in rates could lift consolidated public sector liabilities by as much as half a percent of gross domestic product in just 12 months.

But the combination of higher policy rates and stepping back from the bond market at the same time could be quite a squeeze for financial markets and the wider economy.

Much like the Fed, the process of so-called 'quantitative tightening', or QT, will be passive at first -- the Bank will simply stop re-investing coupon payments and maturing gilts and reduce its holdings as they come due. Outright selling of securities is probably some distance off and will probably depend on how markets react to passive QT first.

And its this last bit makes it all feel like a laboratory experiment for the central banking community as a whole.

They have been here before with the Fed in 2018 and it was far from smooth. Markets wobbled badly by the end of that year.

But this BoE move will mark the first balance sheet retreat since the massive government borrowing explosion everywhere around the pandemic - and will be an important marker in assessing just how sustainable those outsize debts will be.

For the Bank it leaves a sizeable additional hole in the government bond market for private investors to fill. And economists are unsure about just how well the UK economy will be able to absorb a whole host of policy reversals this year - from higher borrowing and mortgage rates to higher taxes and soaring household energy costs.

For other markets, much hinges on how the already aggressive BoE tightening currently priced covers all that.

HSBC's Dominic Bunning reckons the first rundown of the Bank's balance sheet - which ballooned to more than 40% of UK gross domestic product during the pandemic - will be a "big step" but won't see a "sudden jolt" in debt yields or sterling.

DOUBLE TIGHTENING

HSBC estimates that the run off will be relatively gentle at first, with the 72 billion pounds ($96 billion) that passive QT will pare off the balance sheet by the end of next year less than 10% of the Bank's total holdings.

Bunning adds that although the Fed will start later, its passive QT will be much faster over that period - with almost 15% likely to go by the end of 2023.

What's more, he reckons already aggressive pricing of UK rates markets probably covers this "double tightening" effect right now and the so-called 'terminal rate' for Bank of England hikes will remain below the Fed's. There was little historical evidence that switching foreign investor gilt buying for the BoE's absence will lift the pound, Bunning added.

Sterling's steep slide against dollar this week even as markets braced for next Thursday's BoE meeting and two-year gilt yields hit their highest in 10 years speaks to that. The UK yield curve from two to 10 years remains at its flattest since the early stages of the pandemic - a third of where it was in the middle of last year.

Deutsche Bank's Sanjay Raja says the Bank is clearly more worried that accelerating wage rises will entrench the hottest UK inflation rate in decades as labour and goods supply problems persist well into the new year.

Even one of the more dovish Bank policymakers Catherine Mann last week acknowledged the Bank now had to "lean against" these pressures.

But Raja says the early tightening moves - combined with the hit to UK demand from energy prices and tax rises - should allow the Bank to slow the pace of policy rate hikes even if it were to more actively sell down its balance sheet as rates hit 1.0%.

Deutsche expects another rate hike in August, with two more six months apart in 2023 - taking the terminal rate to 1.25%.

But there are clearly risks to this, given the way the market is already priced. Futures markets already see rates at 1.25% by March next year and a terminal rate about 1.5% in June.

"While not our base case at this stage, a slightly more aggressive wind down of the Bank's balance sheet should not be discounted and indeed looks a little more likely than before," Raja wrote.

The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own

(By Mike Dolan, Twitter: @reutersMikeD; Editing by Edmund Blair)