The Bank of England has defended last week’s intervention in the UK government debt market, saying it stepped in to prevent a £50bn fire sale of gilts that would have taken Britain to the brink of a financial crisis.
The central bank said on Thursday that had it not launched its emergency bond-buying scheme in the wake of chancellor Kwasi Kwarteng’s “mini” Budget, pension funds would have been forced to sell £50bn worth of long-term UK government debt “in a short space of time”. This would far exceed the average daily trading volume of £12bn.
The BoE’s defence of the scheme, in which it said it would buy up to £65bn in gilts over a 13-day period, is the clearest sign yet of how close the UK came to a market meltdown following Kwarteng’s plan for £45bn in unfunded tax cuts.
Had the central bank not intervened, it feared there would have been a “self-reinforcing spiral” that threatened “severe disruption of core funding markets and consequent widespread financial instability”, said Sir Jon Cunliffe, the BoE’s deputy governor for financial stability, in a letter to the chair of parliament’s Treasury committee.
The letter also provided details on warnings received by the BoE ahead of its intervention. Cunliffe said that managers of the liability-driven investment strategies at the centre of a crisis in Britain’s pension fund industry had warned as early as Friday September 23 that the huge moves in gilt yields would force them to dump large quantities of government debt.
The warnings continued during the day and into the evening on Monday, although a fall in 30-year gilt yields on Tuesday morning offered hope of “a somewhat more orderly liquidation of long-term gilts by LDI fund managers”, Cunliffe’s letter said.
But as the selling resumed, a number of LDI investors warned that their funds were likely to fall into negative net asset value, forcing them to wind up leveraged bets on interest rates that they use to manage the swings in the value of their long-term liabilities to pensioners. That in turn would have led banks that lent to the funds to sell the gilts used to back these bets, creating a downward spiral in gilt prices.
Long-term borrowing costs, which had surged to their highest level in two decades, plunged after the BoE announced its intervention. The overall move in 30-year gilt yields on September 28 of 1.27 percentage points was larger than the annual trading range for the bonds in all but four of the last 27 years, the letter said.
The BoE has spent just £3.8bn in the first seven days of its programme, far below the potential maximum of £35bn. Investors and traders in the gilt market said the possibility of larger central bank purchases had been successful in backstopping the market and giving other buyers the confidence to step in.
However, yields have begun to move higher again this week after the BoE bought no bonds at all on Tuesday and Wednesday. Thirty-year borrowing costs traded at 4.37 per cent on Thursday morning, up from a low of 3.64 per cent in the wake of the BoE’s intervention, but below the 20-year high of more than 5 per cent that forced the central bank to act.
Cunliffe also responded to concerns that the gilt-buying intervention, which is due to end on October 14, undermines the BoE’s fight to bring inflation under control by in effect loosening monetary policy. “These operations are not intended to create central bank money on a lasting basis, nor are they designed to cap or control long-term interest rates,” he wrote.
Alongside last week’s gilt purchases, the central bank also delayed the start of sales of gilts from its portfolio in a bid to shrink its balance sheet — a process that forms part of the BoE’s plans to tighten monetary policy. Cunliffe reiterated that this so-called “quantitative tightening” is scheduled to begin on October 31.
Timeline: How the UK came to the brink of a financial crisis
September 23: Kwasi Kwarteng’s “mini” Budget sparks a 4 per cent drop for sterling against the dollar and a bigger sell-off in long-term gilts. Liquidity conditions were “very poor” in bond markets, meaning it was difficult to buy and sell the debt, and liability-driven investment strategies (LDI) fund managers raise concerns to BoE officials about the implications of the moves.
September 26: The gilt selling accelerates and LDI investors tell the BoE that they could be forced to sell at least £50bn of bonds if market conditions persist. Pound tumbles to historic low against the US dollar before recovering.
September 27: The rout in gilts eases in the morning, potentially buying time for an orderly unwind of leveraged pension fund trades. But then the rise in yields resumes, triggering warnings that “multiple” pension funds are likely to fall into negative net asset values. BoE staff work overnight to design a market intervention.
September 28: The gilt retreat continues until the BoE announced its gilt-buying plans late in the morning, sparking a huge fall in long-term gilt yields.
Source: FT research, Bank of England statement