Pension fund panic led to Bank of England’s emergency intervention

The Bank of England on Wednesday launched a historic intervention within the U.Okay. bond market so as to shore up financial stability, with markets in disarray following the brand new authorities’s fiscal coverage bulletins.

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LONDON – The Bank of England launched a historic intervention to stabilize the U.Okay. financial system, asserting a two-week buy program for long-dated bonds and delaying its deliberate gilt gross sales till the tip of October.

The transfer got here after a large sell-off in U.Okay. authorities bonds — often called “gilts” — following the brand new authorities’s fiscal coverage bulletins on Friday. The insurance policies included massive swathes of unfunded tax cuts which have drawn international criticism, and likewise noticed the pound fall to an all-time low in opposition to the greenback on Monday.

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The choice was taken by the Bank’s Financial Policy Committee, which is mainly liable for guaranteeing financial stability, relatively than its Monetary Policy Committee.

To stop an “unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy, the FPC said it would purchase gilts on “no matter scale is critical” for a limited time.

Central to the Bank’s extraordinary announcement was panic among pension funds, with some of the bonds held within them losing around half their value in a matter of days. 

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The plunge in some cases was so sharp that pension funds began receiving margin calls — a demand from brokers to increase equity in an account when its value falls below the broker’s required amount.

Long-dated bonds represent around two-thirds of Britain’s roughly £1.5 trillion in so-called Liability Driven Investment funds, which are largely leveraged and often use gilts as collateral to raise cash. 

These LDIs are owned by final salary pension schemes, which risked falling into insolvency as the LDIs were forced to sell more gilts, in turn driving down prices and sending the value of their assets below that of their liabilities. Final salary, or defined benefit, pension schemes are workplace pensions popular in the U.K. that provide a guaranteed annual income for life upon retirement based on the worker’s final or average salary.

In its emergency purchase of long-dated gilts, the Bank of England is setting out to support gilt prices and allow LDIs to manage the sale of these assets and the repricing of gilts in a more orderly fashion, so as to avoid a market capitulation.

The Bank said it would commence buying up to £5 billion of long-dated gilts (those with a maturity of more than 20 years) on the secondary market from Wednesday until Oct. 14. 

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The expected losses, which could eventually take gilt prices back to where they were before the intervention, but in a less chaotic manner, will be “absolutely indemnified” by the U.K. Treasury. 

The Bank retained its target of £80 billion in gilt sales per year, and delayed Monday’s commencement of gilt selling — or quantitative tightening — until the end of October. However, some economists believe this is unlikely.

“There is clearly a financial stability facet to the BoE’s choice, but additionally a funding one. The BoE seemingly will not say it explicitly however the mini-budget has added £62 billion of gilt issuance this fiscal 12 months, and the BoE growing its inventory of gilts goes a great distance in the direction of easing the gilt markets’ funding angst,” explained ING economists Antoine Bouvet, James Smith and Chris Turner in a note Wednesday. 

“Once QT restarts, these fears will resurface. It would arguably be a lot better if the BoE dedicated to buying bonds for an extended interval than the 2 weeks introduced, and to droop QT for even longer.”

A central narrative emerging from the U.K.’s precarious economic position is the apparent tension between a government loosening fiscal policy while the central bank tightens to try to contain sky-high inflation.

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“Bringing again bond purchases within the title of market functioning is probably justified; nonetheless, this coverage motion additionally raises the specter of financial financing which can add to market sensitivity and power a change of method,” said Robert Gilhooly, senior economist at Abrdn.

“The Bank of England stays in a really powerful spot. The motivation for ‘twisting’ the yield curve could have some advantage, however this reinforces the significance of near-term tightening to guard in opposition to accusations of fiscal dominance.”

Monetary financing refers to a central bank directly funding government spending, while fiscal dominance occurs when a central bank uses its monetary policy powers to support government assets, keeping interest rates low in order to reduce the cost of servicing sovereign debt.

Further intervention?

The Treasury said Wednesday that it fully supports the Bank of England’s course of action, and reaffirmed Finance Minister Kwasi Kwarteng’s commitment to the central bank’s independence. 

Analysts are hoping that a further intervention from either Westminster or the City of London will help assuage the market’s concerns, but until then, choppy waters are expected to persist.

Dean Turner, chief euro zone and U.K. economist at UBS Global Wealth Management, said investors should watch the Bank of England’s stance on interest rates in the coming days. 

The Monetary Policy Committee has so far not seen fit to intervene on interest rates prior to its next scheduled meeting on Nov. 3, but Bank of England Chief Economist Huw Pill has suggested that a “important” fiscal event and a “important” plunge in sterling will necessitate a “important” interest rate move. 

UBS does not expect the Bank to budge on this, but is now forecasting an interest rate hike of 75 basis points at the November meeting, but Turner said the risks are now skewed more toward 100 basis points. The market is now pricing a larger hike of between 125 and 150 basis points.

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“The second factor to watch will likely be modifications to the federal government’s place. We ought to be in little question that the present market strikes are the outcome of a fiscal occasion, not a financial one. Monetary coverage is attempting to mop-up after the milk was spilt,” Turner said.

The Treasury has promised a further update on the government’s growth plan, including costing, on Nov. 23, but Turner said there is now “each probability” that this is moved forward or at least prefaced with further announcements.

“If the chancellor can persuade buyers, particularly abroad ones, that his plans are credible, then the present volatility ought to subside. Anything much less, and there’ll seemingly be extra turbulence for the gilt market, and the pound, within the coming weeks,” he added.

What now for sterling and gilts?

Following the Bank’s bond market intervention, ING’s economists expect a little more sterling stability, but noted that market conditions remain “febrile.”

“Both the robust greenback and doubts about UK debt sustainability will imply that GBP/USD will battle to maintain rallies to the 1.08/1.09 space,” they said in Wednesday’s note.

This proved the case on Thursday morning as the pound fell 1% against the greenback to trade at around $1.078.

Bethany Payne, global bonds portfolio manager at Janus Henderson, said the intervention was “solely a sticking plaster on a a lot wider downside.” She suggested the market would have benefitted from the government “blinking first” within the face of the market backlash to its coverage agenda, relatively than the central financial institution.

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“With the Bank of England shopping for long-dated bonds, and due to this fact displaying willingness to restart quantitative easing when markets develop into jittery, this could present some consolation to buyers that there’s a gilt yield backstop,” Payne said. 

Coupled with a “comparatively profitable” 30-year gilt syndication on Wednesday morning, in which total interest was £30 billion versus £4.5 billion issued, Payne suggested there was “some consolation to be had.” 

“However, elevating financial institution fee whereas additionally participating in quantitative easing within the brief run is a unprecedented coverage quagmire to navigate, and probably speaks to a continuation of foreign money weak spot and continued volatility.”

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