Ahead of the Bank of England's rate decision scheduled for 7:00 PM Beijing time on Thursday, market consensus points to the central bank holding its benchmark rate steady at 3.75%. Yet, the energy price shock stemming from the Middle East conflict has ignited intense debate among policymakers and investors over the possibility of further rate hikes. Market participants are particularly keen to discern any signals from the BOE suggesting that surging energy costs might compel it to follow the Federal Reserve's tightening path, as a hawkish stance could drive gilt yields higher.

Nevertheless, for bond investors, the central bank's quantitative tightening program over the coming year takes precedence over Thursday's rate announcement. Alongside the rate decision, the BOE will release its annual update detailing plans to shrink its balance sheet through government bond sales. The bond market's key question revolves around whether the BOE will reduce or even suspend its active selling of holdings, with any cutback in active sales potentially providing a boost to gilts.

Since February 2022, the BOE has trimmed its bond portfolio from nearly double its size to £489 billion. The central bank has stated its intention to fully divest its holdings, guided by three principles: the bank rate remains the Monetary Policy Committee's primary tool, sales must not disrupt market functioning, and the process should be gradual and predictable. Strategist Evelyne Gomez-Liechti from Mizuho noted that QT stands out as the more significant market event, with its announcement potentially carrying greater weight than the interest rate decision itself. Her baseline scenario anticipates the BOE abandoning active sales and shifting solely to passive QT, where bonds are allowed to mature naturally, a move she believes would support gilts.

The BOE's QT initiative revolves around the phased exit from government bonds acquired under pandemic-era quantitative easing. These sales have been under close market scrutiny due to their potential to exacerbate selling pressure, particularly as the recent selloff has pushed long-term UK financing costs to their highest levels since 1998 and strained the government's fiscal headroom. Long-dated gilt yields are hovering near those 1998 peaks. Remi Olu-Pitan, head of multi-asset growth and income at Schroder, expressed confidence that the central bank, as lender of last resort, will eventually need to step in to back gilts, arguing that action is necessary if yields continue climbing.

Strategists Fabio Bassanin and Luca Salford from Morgan Stanley pointed out that a substantial increase in gilt issuance combined with reduced BOE holdings has had a more pronounced impact on long-dated gilts, especially as pension fund demand for such bonds has weakened in recent years. They estimate that QT has added roughly 70 basis points to 30-year gilt yields. Data shows that the premium of 30-year gilts over comparable swap rates, a gauge of market anxiety over supply, has remained broadly steady this year despite the sharp yield surge.

Survey data indicates market participants expect the BOE to slow its balance sheet runoff to around £50 billion annually over the twelve months through October, implying roughly £20 billion in active gilt sales. However, speculation resurfaced earlier this week following reports that the BOE might entirely halt sales of long-dated debt. This comes amid criticism of the program, given that active sales are currently generating losses and costing the government billions of pounds. Even if the BOE stops selling gilts, the impact may prove marginal, as gilt markets remain vulnerable to external shocks such as rising oil prices from Middle East tensions that amplify inflation concerns.

Some market watchers caution that the BOE may refrain from major adjustments beyond consensus expectations, citing concerns that altering its bond-selling strategy to accommodate government fiscal needs could raise doubts about its independence. Strategist Jamie Searle from Citigroup acknowledged that while a policy shift is possible, he suspects the central bank will maintain the status quo to avoid undermining QT's credibility as a monetary policy tool.