Monday’s sharpest moves were concentrated in the index-linked gilt market — illiquid bonds where payouts to bondholders are benchmarked in line with the U.K. retail price index.
The scale of the rise in bond yields — which move inversely to prices — prompted the Bank to expand its emergency bond purchase program on Tuesday to include index-linked gilts until the deadline on Friday. In a statement, the Bank said dysfunction in the index-linked gilt market posed a “material risk to U.K. financial stability.”
The Bank’s initial temporary rescue measures on Sep. 28 were launched after warnings from liability driven investment (LDI) funds that they faced imminent collapse as a result of the capitulation in long-dated U.K. government bond prices.
Yields cooled modestly after Tuesday’s expansion to the purchase program to capture index-linked gilts, which followed a decision Monday to increase the daily limit for gilt purchases, but remained near levels seen before the Bank’s first intervention.
Analysts broadly expect volatility to continue in the coming weeks, at least until Finance Minister Kwasi Kwarteng’s make-or-break fiscal policy announcements on Oct. 31. Kwarteng announced on Monday that the medium-term fiscal plan would be brought forward three weeks from its scheduled date as the Treasury looks to assuage market fears.
Kwarteng’s initial “mini-budget” announcement on Sep. 23 sent markets into turmoil and was widely criticized for its swathe of debt-funded tax cuts aimed at high earners and corporations, with the government claiming that its plan would drive economic growth.
Yields heading ‘in one direction only’
Also on Oct. 31, the Bank of England plans to begin its delayed sale of gilts as part of a wider quantitative tightening effort and unwinding of pandemic-era monetary stimulus. The Monetary Policy Committee will not meet again until Nov. 3, after the scheduled recommencement of gilt sales.
Several strategists have attributed the lingering skittishness in bond markets, despite the Bank’s efforts, to the limited timescale of its intervention and the prospect of gilt sales beginning again. Others have pointed to uncertainty over whether the government can re-establish credibility with its fiscal policy projections at the end of the month.
Stuart Cole, head macro economist at brokerage Equiti Capital, said the sequence of announcements from the Bank of England since its initial intervention may suggest that it is starting to “lose control” of the gilt market.
“It has to tighten policy to try and get inflation back under control, but at the same time it is engaging in what is, effectively, a further bout of quantitative easing, and so far we have not really had any signs from the Government that it is considering reversing more of the measures announced end-September,” Cole told CNBC via email.
“The market can smell blood and is taking the view that, if the BoE sticks to its plans and ceases its intervention this week, then with no response expected from the Government, and with pressure on the BoE to raise rates more forcefully at the November MPC meeting, yields will be heading in one direction only.”
Based on analysis of the Bank of England’s bond purchases so far, strategists at RBC highlighted in a note Tuesday that the program is not designed to drive yields down, but rather to offer investors who are desperate to sell a means through which to do so.
“This is not the same goal as with the original ‘QE’ programmes where the BoE went into the market with a size target and actively influenced the price. This should give us pause for the coming weeks,” RBC Global Macro Strategist Peter Schaffrik said.
“If the market is already shifting yields aggressively higher with the BoE in the market on the buying side, how will the market deal with an active QT programme, where a predefined size will have to be pushed into the market?”
For this reason, RBC said there is a “distinct possibility” that the Bank of England reconsiders whether to press ahead with its quantitative tightening program, scheduled to begin on Oct. 31 and targeting £80 billion ($88.8 billion) in annual gilt sales.
Schaffrik suggested that the date clash of the government’s medium-term fiscal plan and forecasts, and the beginning of the Bank’s QT program may offer the central bank cover to delay the start, and allow the MPC to assess the market reaction to the Treasury’s plan.
The next few days will be a ‘rollercoaster’
Through its relatively tepid response to inflation earlier in the year, some economists believe the Bank laid the foundations for the volatility and illiquidity currently plaguing the U.K. bond market.
James Athey, investment director at Abrdn, noted Tuesday that the Bank’s decisions are now more fraught, as a lack of aggression will be perceived as weakness by the market, while an overly exuberant reaction could be interpreted as panic.
“Their recent attempts to deal with weakness and volatility in U.K. asset markets, ably assisted by the pernicious impact of excess and unwise leverage in the LDI sector, are but mere sticking plasters,” Athey said.
“As ever though the maxim will hold true – there is nothing so permanent as a temporary government program and the risk for the Bank is that they have already trapped themselves into a program of asset purchases at a time where their mandate dictates they should be withdrawing liquidity to tighten policy.”
As the impending deadline for the temporary gilt purchases draws nearer with neither market weakness nor volatility having “meaningfully subsided,” Athey suggested the next few days are likely to be a “rollercoaster,” regardless of what the Bank eventually decides to do.