UK : fear that things can get worse
By Jim Leaviss, CIO of Public Fixed Income at M&G Investments
After last week Friday’s mini-Budget in the UK sent the pound plummeting and government bond (gilt) yields higher, stresses in the UK pension market became so severe that the Bank of England (BoE) has been forced to step in and announce a gilt-buying programme. It will be buying long-dated gilts, starting yesterday with up to £5.0 billion, in a reverse auction process. Of course, the very announcement of such support has been enough to send gilt yields down significantly, with 30-year gilts, which approached 5% the previous day, down nearly 1.1 percentage point in yield to below 4%. The impact of such yield changes on price is extreme for these long duration assets. The 30-year gilt (1.25% for 2051 gilts) was up nearly 11 basis points from Tuesday’s close. In the days since the mini-Budget it had fallen from around a price of 60 to just over 40 (pence in the pound). The price (as at Wednesday, 28 September) = 54.20.
Why has the Bank intervened?
Pension funds have found themselves short of liquid collateral1 to pay to counterparties with which they have taken out interest rate or inflation swaps. As yields rose as a result of Friday’s announcement of unfunded tax cuts for the rich (and therefore expectations of more government bond issuance), pension funds with these LDI (Liability Driven Investment) swaps found themselves having to post collateral to cover mark-to-market losses. Some of them therefore had to liquidate other investments to do so – including gilts, sending yields up further and exacerbating the problem. This is purely a liquidity problem – pension funds are solvent, and indeed for many of them higher yields actually reduce their funding deficits and would be good news in a less extreme scenario.
What could the Bank do? It was frightened that this could become a systemic problem (‘a material risk’) for the UK economy (a financial stability issue). It has not talked about the impact of higher yields on economic activity, but obviously higher gilt yields feed through into higher borrowing costs for households and businesses too. It is keen that this is seen as an operation to reduce strains in a particular market – not a reopening of Quantitative Easing! But like it or not, it will loosen monetary policy, at a time where Huw Pill (Chief Economist at the Bank of England) is talking up the chances of more rate hikes to dampen the inflation impact of the mini-Budget. The money market is still pricing in 175 basis points of Bank hikes at the next MPC meeting in November – the yield curve is therefore very inverted, with short-dated yields higher than long-dated yields. Gilt sales from the Bank’s balance sheet – Quantitative Tightening, which were due to start next week – have been postponed until the end of October, although it still plans to sell £80 billion of gilts over the next year.
All eyes on speeches at the Conservative party conference in October
The BoE having to intervene to mitigate the damage done by the government is not a good look. The IMF – which traditionally raises its eyebrows at emerging markets finance ministers – took the unusual step of criticising UK policy on Tuesday night. We have the ratings agencies also waiting in the wings, and a credit rating downgrade is a possibility too. All eyes are now on speeches from the new Prime Minister and Chancellor at the imminent Conservative Party conference (due to take place between October 2 and 5 in Birmingham) – there is a fear that there is nothing they can say that won’t make things worse.
1 Further reading : https://bondvigilantes.com/blog/2022/09/collateral-calls/
