The Bank of England launched a historic intervention in the UK bond market on Wednesday to bolster financial stability, with markets in disarray after the new government’s fiscal policy announcements.
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LONDON – The Bank of England launched a landmark intervention to stabilize the UK economy by announcing a two-week long-term bond buying program and framing the planned sale of gold until the end of October.
The move came after a massive sell-off of UK government bonds – known as “gilts” – following the new government’s fiscal policy announcements on Friday. The policy included large chunks of unfunded tax cuts that have sparked worldwide criticism, and also saw the pound fall to an all-time low against the dollar on Monday.
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The decision was taken by the Bank’s Financial Policy Committee, which is primarily responsible for ensuring financial stability, and not by the Monetary Policy Committee.
To avoid an “unwarranted tightening of financing conditions and a reduction in the flow of credit to the real economy, the FPC said it would buy gold at “any scale needed” for a limited time.
Central to the Bank’s extraordinary announcement was panic among pension funds, with some of the bonds held in it losing about half of their value within days.
The plunge has been so sharp in some cases that pension funds have started to receive margin calls — a broker’s requirement to increase equity in an account when its value falls below the broker’s required amount.
Long-term bonds represent about two-thirds of Britain’s roughly £1.5 trillion in so-called Liability Driven Investment funds, which are largely leveraged and often use government bonds as collateral to raise cash.
These LDIs are owned by final pay pension plans, which were in danger of becoming insolvent as the LDIs were forced to sell more government bonds, causing prices to fall and the value of their assets below that of their liabilities. Final pay or defined benefit plans are occupational pensions popular in the UK that offer a guaranteed lifelong annual income upon retirement based on the employee’s last or average salary.
With its emergency purchase of long-term government bonds, the Bank of England aims to support gold prices and enable LDIs to manage the sale of these assets and the price revision of gilts in a more orderly manner, in order to avoid a market capitation.
The Bank said it would start buying up to £5bn worth of long-term government bonds (those with maturities over 20 years) in the secondary market from Wednesday to 14 October.
The expected losses, which could eventually bring gold prices back to where they were before the intervention, but in a less chaotic manner, will be “fully reimbursed” by the British Treasury.
The Bank maintained its target of £80bn in gold sales per year, and on Monday postponed the start of sales of gilding – or quantitative tightening – until the end of October. However, some economists think this is unlikely.
“There is clearly an aspect of financial stability to the BoE’s decision, but also to the funding. The BoE probably won’t say it explicitly, but the mini-budget has added £62 billion in government bonds this fiscal year, and the BoE is raising its Gold stocks are helping a lot to ease government bond financing fears,” ING economists Antoine Bouvet, James Smith and Chris Turner said in a note on Wednesday.
“Once QT restarts, these fears will resurface. Arguably, it would be much better if the BoE committed to buying bonds for a longer period than the two announced weeks, and suspending QT even longer.”
A central story emerging from the UK’s precarious economic position is the apparent tension between a government easing fiscal policy and the central bank to try and contain skyrocketing inflation.
“Reducing bond purchases in the name of market functioning may be warranted; however, this policy action also raises the specter of monetary financing, which could increase market sensitivity and force a change in approach,” said Robert Gilhooly, senior economist at Abrdn.
“The Bank of England is still in a very difficult position. The motivation to ‘twist’ the yield curve may have some merit, but this reinforces the importance of short-term tightening to guard against accusations of fiscal dominance.”
Monetary financing refers to a central bank that directly finances government spending while fiscal dominance occurs when a central bank uses its monetary policy powers to support government assets, keeping interest rates low to lower the cost of paying off government debt.
The Treasury Department said on Wednesday that it fully supports the Bank of England’s actions, and reaffirmed Finance Minister Kwasi Kwarteng’s commitment to central bank independence.
Analysts hope further intervention from Westminster or the City of London will help allay market concerns, but until then the troubled waters are expected to continue.
Dean Turner, Eurozone chief and UK economist at UBS Global Wealth Management, said investors should pay attention to the Bank of England’s stance on interest rates in the coming days.
The Monetary Policy Committee has so far deemed inappropriate to intervene on interest rates before its next scheduled meeting on November 3, but Huw Pill, chief economist at the Bank of England, has suggested that a “major” fiscal event and a “significant” dip in sterling will necessitate a “significant” movement in interest rates.
UBS doesn’t expect the Bank to budge, but is now forecasting a 75 basis point rate hike at its November meeting, but Turner said risks are now moving closer to 100 basis points. The market is now calculating a larger increase from 125 to 150 basis points.
“The second thing to look out for is changes in the government’s position. We can’t doubt that current market movements are the result of a fiscal event, not a monetary spill,” Turner said.
The Treasury Department has promised a further update on the government’s growth plan, including costs, on Nov. 23, but Turner said there is now “every chance” that it will continue or at least be preceded by further announcements.
“If the Chancellor can convince investors, especially foreigners, that his plans are credible, then current volatility should ease. Anything less, and there will likely be more turbulence for the gold market and the pound in the coming weeks,” he added.
What about sterling and gold plating?
After the bank’s intervention in the bond market, ING economists expect some more stability in the British pound, but noted that market conditions remain “fever”.
“Both the strong dollar and doubts about the sustainability of UK debt will mean that GBP/USD will struggle to sustain rallies towards the 1.08/1.09 area,” they said in Wednesday’s note.
This proved the case on Thursday morning, when the pound fell 1% against the greenback to trade around $1,078.
Bethany Payne, global bonds portfolio manager at Janus Henderson, said the intervention was “just a plaster on a much broader problem”. She suggested the market would have benefited from the government “blinking first” in light of the market’s response to its policy agenda, rather than the central bank.
“With the Bank of England buying long-term bonds and therefore willing to restart QE when markets get jittery, this should give investors some comfort that there is a backstop to gilded returns,” Payne said.
Coupled with a “relatively successful” 30-year Treasury bond syndication on Wednesday morning, in which total interest was £30bn versus £4.5bn issued, Payne suggested there was “some consolation”.
“However, raising bank rates while at the same time short-term quantitative easing is an extraordinary policy swamp to navigate, and potentially speaks to a continuation of currency weakness and ongoing volatility.”