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Panic in the pension fund led to emergency intervention by the Bank of England

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

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LONDON – The Bank of England launched a historic intervention to stabilize the UK economyby announcing a two-week program of buying long-term bonds and postponing planned sales of gilt bonds until the end of October.

The move follows a massive sell-off in UK government bonds – known as “gilts” – following the new government’s fiscal policy announcements on Friday. The policy included large swathes of unwarranted tax cuts, drawing worldwide criticism and also seeing The pound fell to an all-time low against the dollar on Monday.

This decision was made by the Bank’s Financial Policy Committee, which is responsible for ensuring financial stability, and not by the Monetary Policy Committee.

To prevent an “undue tightening of funding conditions and a reduction in the flow of credit to the real economy,” the FPC said it would purchase gilts on “any necessary scale” for a limited time.

At the center of the Bank’s extraordinary statement was panic among pension funds, which saw some of the bonds held by them lose around half their value in a matter of days.

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In some cases, the decline was so sharp that pension funds began to receive margin calls – requests from brokers to increase the capital in the account if its value falls below the amount required by the broker.

Long-term bonds make up about two-thirds of the roughly £1.5 trillion in so-called bond-managed investment funds, which rely heavily on debt and often use gilts as collateral to raise money.

These LDIs belong to final salary pension schemes that are at risk of becoming insolvent as the LDIs have been forced to sell more gilts, in turn driving down prices and sending the value of their assets below their liabilities. Final salary or defined benefit pension schemes are workplace pensions popular in the UK that provide a guaranteed annual income for life after retirement based on an employee’s final or average salary.

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

The bank has announced that it will start buying up to £5bn of long-dated gilts (with maturities of more than 20 years) in the secondary market from Wednesday to October 14.

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The expected losses, which could eventually return gilt prices to where they were before the intervention, but in a less chaotic fashion, will be “fully compensated” by the UK Treasury.

The bank kept its target of 80 billion pounds of gilt sales for the year and delayed Monday’s start of gilt sales — or quantitative tightening — until the end of October. However, some economists consider this unlikely.

“There is clearly a financial stability aspect to the Bank of England’s decision, but also a funding aspect. The Bank of England is unlikely to say it outright, but the mini-budget has added £62bn of gilt issuance this financial year and the BoE increasing its gilt holdings will go a long way to easing funding fears in the gilt markets,” explained ING economists Antoine Bouvet, James Smith and Chris Turner in a note on Wednesday.

“Once QT restarts, those concerns will resurface. Perhaps it would be much better if the Bank of England committed to buying bonds for a longer period than the two weeks announced and suspended QT for an even longer period.’

The main narrative emerging from Britain’s precarious economic position is the apparent tension between the government’s easing of fiscal policy and central bank tightening to try to contain skyrocketing inflation.

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

“The Bank of England is still in a very difficult position. The motivation to ‘bend’ the yield curve may have some merit, but it reinforces the importance of tightening in the near term to defend against accusations of financial dominance.”

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

Further intervention?

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

Analysts hope that further intervention from Westminster or the City of London will help calm market concerns, but until then, the situation is expected to remain volatile.

Dean Turner, chief economist for the eurozone and UK-based UBS Global Wealth Management, said investors should keep an eye on the Bank of England’s interest rate stance in the coming days.

The Monetary Policy Committee has so far not seen fit to intervene in interest rates until its next scheduled meeting on November 3, but the Bank of England’s chief economist, Hugh Peel, suggested that a “significant” fiscal event and a “significant” fall in sterling would require “significant ” interest rate changes.

UBS does not expect the bank to back down, but now forecasts a 75 basis point rate hike at the November meeting, but Turner said the risks are now more inclined to 100 basis points. The market now expects a bigger price hike of 125 to 150 basis points.

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“The second thing to watch is changes in the government’s stance. We should be in no doubt that the current market dynamics are the result of a fiscal event, not a monetary one. Monetary policy is trying to clean up the spilled milk,” Turner said. .

The Treasury promised a further update on the government’s growth plan, including spending, on November 23, but Turner said there was now “every chance” it would be brought forward, or at least announced earlier.

“If the chancellor can convince investors, especially foreign investors, that his plans are credible, then the current volatility should decrease. Anything less is likely to mean more turbulence in the gold and pound markets in the coming weeks,” he added.

What now with sterling and gilts?

Following the Bank’s intervention in the bond market, ING economists expect slightly more stability in sterling, but noted that market conditions remain “feverish”.

“Both a strong dollar and doubts about UK debt sustainability will mean GBP/USD will struggle to climb to the 1.08/1.09 area,” it said in a note on Wednesday.

This was confirmed on Thursday morning, when the pound fell 1% against the dollar to trade around $1.078.

Bethany Payne, portfolio manager of global bonds at Janus Henderson, said the intervention was “just a Band-Aid for a much wider problem”. She suggested that the market would benefit from the government “blinking first” in the face of market backlash to its policy plan, rather than the central bank.

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“With the Bank of England buying long-dated bonds and thus showing a willingness to resume quantitative easing when markets start to get jittery, this should give investors some comfort that the protection of gilt yields is in place,” Payne said.

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

“However, raising bank rates as well as engaging in quantitative easing in the short term is an extreme policy quagmire to overcome and potentially signals continued currency weakness and continued volatility.”

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