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

The Bank of England on Wednesday launched a historic intervention in the UK bond market to bolster financial stability, with markets in disarray following the new government’s fiscal policy announcements.

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LONDON – The Bank of England launched a historic intervention to stabilize the British economy, announcing a two-week buying program for long-dated bonds and delaying its planned gold sale until the end of October.

The move came after a massive sell-off in UK government bonds ̵[ads1]1; known as “gilts” – following the new government’s fiscal policy announcements on Friday. The guidelines included large chunks of unfunded tax cuts that have drawn global criticism and also saw the pound fall to a record low against the dollar on Monday.

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The decision was taken by the bank’s fiscal policy committee, which is primarily responsible for ensuring financial stability, and not by the bank’s monetary policy committee.

To prevent 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 to “whatever extent necessary” for a limited period.

Central to the bank’s extraordinary announcement was panic among the pension funds, where some of the bonds in them lost around half of their value within a few days.

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

Long-dated bonds represent about two-thirds of Britain’s roughly 1.5 trillion pounds in so-called Liability Driven Investment Funds, which are heavily leveraged and often use gilts as collateral to raise money.

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

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

The bank said it would start buying up to £5bn of long-dated gilts (those with a maturity of more than 20 years) on the secondary market from Wednesday to 14 October.

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The expected losses, which could eventually bring gilt prices back to pre-intervention levels but in a less chaotic fashion, will be “fully indemnified” by the UK Treasury.

The bank kept its target of £80 billion in gold sales per year, delaying Monday’s launch of gold sales – or quantitative easing – until the end of October. However, some economists believe that this is unlikely.

“There is clearly a financial stability aspect to the BoE’s decision, but also a funding one. The BoE probably won’t say it explicitly, but the mini-budget has added £62bn of gilt issuance this financial year, and the BoE increasing its stock of gilts goes a long way towards easing funding anxiety in gilt markets,” ING economists Antoine Bouvet, James Smith and Chris Turner explained in a note on Wednesday.

“When QT restarts, these fears will resurface. It would arguably be much better if the BoE committed to buying bonds for a longer period than the two weeks announced, and to suspend QT even longer.”

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

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“Bringing back bond purchases in the name of market functioning is potentially justified; however, this policy action also raises the specter of monetary financing which could heighten market sensitivity and force a change in approach,” said Robert Gilhooly, senior economist at Abrdn.

“The Bank of England remains in a very tough spot. The motivation to ‘pivot’ 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 directly financing government spending, while fiscal dominance occurs when a central bank uses its monetary policy powers to support government assets, keeping interest rates low to reduce the cost of servicing government debt.

Further intervention?

The Treasury said on Wednesday it fully supports the Bank of England’s action plan, reaffirming Finance Minister Kwasi Kwarteng’s commitment to the central bank’s independence.

Analysts hope that further intervention from either Westminster or the City of London will help quell market concerns, but until then the choppy waters are expected to persist.

Dean Turner, head of the eurozone and UK economist at UBS Global Wealth Management, said investors should keep an eye on 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 in interest rates until the next scheduled meeting on November 3, but Bank of England chief economist Huw Pill has hinted at a “significant” financial event and a “significant” plunge. sterling will necessitate a “significant” interest rate move.

UBS does not expect the bank to budge on this, but is now predicting a 75 basis point rate hike at the November meeting, but Turner said the risk is now more skewed towards 100 basis points. The market is now pricing in a larger rise of between 125 and 150 basis points.

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“The other thing to watch will be changes in the government’s position. We should be in no doubt that the current market movements are the result of a fiscal event, not a monetary one. Monetary policy is trying to dry up after the milk was spilled,” Turner said .

The Treasury has promised a further update on the government’s growth plan, including costing, on November 23, but Turner said there was now “every chance” this would be brought forward or at least preceded by further announcements.

“If the chancellor can convince investors, especially overseas, that his plans are credible, the current volatility should ease. Anything less and there is likely to be more turbulence for the gilt market, and the pound, in the coming weeks.” he added.

What now for sterling and gilts?

Following the bank’s bond market intervention, ING’s economists expect slightly more solid stability, but noted that market conditions remain “febrile”.

“Both the strong dollar and doubts about UK debt sustainability will mean that GBP/USD will struggle to hold a rally to the 1.08/1.09 range,” they said in Wednesday’s note.

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

Bethany Payne, global bond portfolio manager at Janus Henderson, said the intervention was “just a Band-Aid on a much bigger problem.” She suggested that the market would have benefited from the government “blinking first” in the face of market backlash to its policy agenda, rather than the central bank.

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“With the Bank of England buying long-dated bonds, and therefore showing willingness to restart quantitative easing when markets get jittery, this should give investors some comfort that there is a golden yield backstop,” Payne said.

Coupled with a “relatively successful” 30-year gilt syndication on Wednesday morning, where total interest was £30bn against £4.5bn issued, Payne suggested there was “some comfort to be had.”

“However, raising bank rates while engaging in short-term quantitative easing is an extraordinary political quagmire to navigate, potentially advocating for continued currency weakness and continued volatility.”

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