The Bank of England raised interest rates by 0.5 percentage points on Thursday.
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LONDON – On Tuesday, the Bank of England announced the expansion of its emergency bond purchases in a bid to restore order to the country’s chaotic bond market.
The central bank said it would expand its purchases of UK government bonds, known as gilts, to include index-linked gilts from October 1. Nov-Oct 14. Index-linked gilts are bonds paid to bondholders based on the UK retail price index.
The move marks the second expansion of the bank’s special rescue program in as many days after it raised the limit on daily Phnom Penh purchases on Monday ahead of a planned end of the buying program on Friday.
The Bank launched emergency intervention in September. An unprecedented sell-off in long-term UK government bonds on January 28 threatens to collapse the multiple liability-driven investment (LDI) fund widely held by UK pension plans.
“The beginning of the week saw a further sharp repricing of UK government debt, particularly index-linked gilts. The dysfunction of this market, and the prospect of a self-reinforcing ‘fire sale’ dynamic pose a significant risk to UK financial stability,” the bank said on Wednesday. Two said in a statement.
The yield on Britain’s 10-year index-linked gilt rose 64 basis points on Monday, with prices down 5.5%. Meanwhile, the price of the index-linked 30-year Treasury note is down 16% on the day, and yields are now around 1.5%, compared with -1.5% six months ago. Yield is inversely proportional to price.
Movements of this magnitude are extremely rare in developed-country sovereign bond markets.
“These additional operations will serve as further support for the return to orderly market conditions by temporarily absorbing the sell-off in index-linked gilts that exceeded the market’s intermediary capacity,” the bank said on Tuesday.
“As with traditional gilt purchases, these additional index-linked gilt purchases will be time-limited and fully compensated by the HM Treasury.”
On Monday, the Bank of England set its daily cap on gilt purchases at 10 billion pounds ($11 billion), of which up to 5 billion pounds will be allocated to traditional gilts and 5 billion pounds to index-linked gilts.
The Bank said the size of the auction would still be under scrutiny and that all purchases would be “conducted in a smooth and orderly manner” once risks to market functioning were judged to have subsided.
After the announcement, the British bond market reaction was subdued. The 10-year yield slipped to 4.426%, while the 30-year yield was roughly flat at 4.713%.
Government must build credibility
Des Lawrence, senior investment strategist at State Street Global Advisors, told CNBC on Tuesday that the Bank of England’s ability to single-handedly stabilize the market is limited.
The wild swings in the bond market were triggered by the controversial fiscal policy announced by Finance Minister Kwasi Kwarteng on September 9. As part of the new government’s goal of boosting economic growth to 2.5 percent, on January 23, it included heavily debt-funded tax cuts.
“The UK government is in a good position in terms of net debt to GDP – around 80%. It’s a pretty good position. What they need to do is explain to investors the credibility behind their economic forecasts, and fairly said, it is completely outside the remit of the Bank of England,” Lawrence said.
In addition to concerns over fiscal credibility that led Moody’s and other credit-rating agencies to downgrade their outlooks on Britain’s sovereign debt, Lawrence said the correlation between long-term U.S. Treasury yields and British gilts also limited the Bank of England’s influence.
Kwarteng announced on Monday that his detailed expansion of his market-plagued policy statement will now take place on Oct. 1. 31, three weeks ahead of schedule. The government has been forced to change some components of its strategy.
Also on Jan. 31, the Bank of England plans to start delaying gilt sales as part of a broader quantitative tightening effort and the removal of pandemic-era monetary stimulus. The Monetary Policy Committee won’t meet again until November. 3. After restarting gilt sales as planned.
Despite the Bank’s efforts, some strategists attributed lingering jitters in bond markets to the limited time for its intervention and the prospect of a restart of gilt sales.
“Removing the emergency quantitative easing Band-Aid – and replacing it with indirect liquidity support – opens the door to repricing UK assets, while (hopefully) preserving the BoE’s credibility and preventing a return of disorder,” Bank of England Deputy Chairman Krishna Guha Evercore ISI said in a research note Monday night.
“We continue to believe that the BoE may have to reschedule or reschedule its QT programme that it promised to resume.”
A key risk now is that Kwarteng’s expanded budget announcement falls short of targets and sparks a fresh round of selling pressure on UK bonds, Guha said.
“The government’s success in improving fiscal credibility will determine the trade-offs faced by banks,” he said.
“If it fails, the market rate curve will shift further up and the central bank will face an almost impossible trade-off between validating these expectations and crushing the economy and housing market, or trying to deliver lower-than-market rates and crashing. Risks to inflation expectations.”