A new government with a misguided spending plan took the UK to the brink of economic chaos last week. The Bank of England says it staved off a £50bn gilts fire sale amid tumbling sterling and spiking bond yields.
It promised to buy long-dated gilts. That pledge is due to expire next Friday. Catastrophists refer to this as a “cliff edge”. Should investors be equally worried?
A replay of the chaos is unlikely. The rush for the door by gilt holders was the result of a feedback loop in the pensions industry which is now fully out in the open.
The trigger was the chancellor’s promise of apparently unfunded tax cuts. As bond yields rose, pension funds were forced to stump up extra collateral for hedges against falling interest rates. The Bank put a ceiling on that cost via its willingness to contain long-dated yields. These are currently at around 4.3 per cent.
The Bank has only used some £4bn of £65bn in firepower mustered against spiking yields. Its willingness to deploy this was enough to forestall panic.
Its day job of controlling inflation would also be easier without the unconventional economics of the Truss government. The chancellor has created a cliff edge of his own by promising to publish a funding plan in the next few weeks.
If this is unrealistic, more market disorder would follow.
The “mini” Budget debacle meanwhile forced the BoE to postpone the start of quantitative tightening. Selling some of the £800bn of gilts its holds would have made it harder to maintain a yield ceiling at the long end of maturities. The bank hopes to begin QT at the end of this month.
BoE boss Andrew Bailey is now governed by expectations rather than governor of them. The threat of financial blow-ups among pension funds may force him to extend price support. And the cost of that would grow if government fiscal policy remains at odds with markets. With QT weakened as a strategy, interest rate decisions matter more. The next move is now more likely to be a steep 125bp rise, taking rates to 3.5 per cent.
Pain for the bank means less of it for investors in long duration gilts. But this comfort is a dish endured cold. The variety of price support most of them would prefer comes from transparent, intelligible policies in vigorous economies. For that, investors whose liabilities have not left them joined at the hip to gilts, must look overseas.
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