Yet Bailey could be redeemed, or at least he has a chance to be lucky. Especially when Chancellor of the Exchequer Kwasi Kwarteng tightens his financial plans. Let me plead the defense.
While the temporary financial stability intervention ends on October 14, the global facility is not going away. The BOE secured a wider order from Kwarteng when it started operations on September 28 that it has up to £100billion if it is ever needed. Bailey might emphasize that BOE can and will make buybacks if a subsequent collapse in market conditions warrants it. For now, the central bank clearly believes that it has bottomed the pension fund horses and that failure to eliminate excessive leverage is ultimately not their responsibility, but that of pension fund managers. The BOE may also introduce another plan that is more geared towards pension funds. Of course, a lot can still go wrong. The law of unintended consequences applies.
However, the BOE does not return to the status quo ante. That’s because, starting October 13, there will be a permanent weekly short-term repo facility alongside other temporary measures. This allows all eligible market participants – not just primary dealers or banks – to raise cash against qualifying Sterling investment grade collateral on a revolving weekly basis every Thursday. These include inflation-linked corporate bonds and a broader range of assets. In short, there shouldn’t be any other major systemic issues that require a sudden need for cash or collateral. When the meltdown began, part of the problem for pension funds was when those margin payments were made on the same day, while cash received from the sale of securities was settled within two or three days.
The market is also turning in Bailey’s favour. Gilt yields at the long end are down 50 basis points after hitting a double top (highs from 28th September and 12th October) just over 5%. This could be explained simply as unusual market volatility, but there is an underlying reason, as evidenced by Wednesday’s breakdown of the large intake of inflation-linked buybacks (known as linkers). To date, pension funds have mostly sold 15-20 year linkers back to the BOE, but gilt market primary dealers have commented on large purchases of extremely long dated linkers. There are some significant portfolio adjustments taking place.
Not all bonds are created equal, and bonds with longer maturities are much more sensitive to changes in interest rates. Funds can maintain or increase exposure by selling shorter-dated gilts for a bond with much longer duration and convexity, freeing up cash to meet their required margin needs. With yields this high, it makes no economic sense for pension funds to collapse bond holdings, only the amount of leverage does. Over time, higher returns will require lower exposure to fixed income assets such as gilts due to UK actuarial pension rules. But after a decade of vanishingly low bond yields, sensible weighting is now being rewarded with significantly higher yields. As The Financial Times’ Toby Nangle explained in more detail, there are some upsides to this crisis.
There was another big take on Thursday’s linker buyback, with £3.1bn accepted, bringing it to a total of £7bn in index-linked gilts bought. This shows that Bailey’s admonitions are working: pension funds are selling directly into buying back the BOE, rather than relying on the secondary market. Likewise, the BOE is much more generous in its pricing. In the conventional buyback segment, £1.6bn was accepted, totaling nearly £11bn of regular gilts bought over the facility’s three weeks. Notably, only £8m of the only eligible green gilts, the 1.5% 2053, have been sold.
Friday is the last opportunity for funds to exit large positions at once near the prevailing market price. Expect one last commotion that will bring the total purchased by the BOE to around £25bn in cash, or more than a third of the notional £65bn facility. A carefully executed big bar of reintroducing buybacks could do wonders for market morale, although the BOE needs to be careful not to open itself up to accusations of Bank of Japan-style yield curve control.
Finally, there is a silver lining to the government bond delivery timeline. Following the 2051 gilt sale on October 18, no Debt Management Office (DMO) plans to auction index-linked bonds maturing beyond 2039 or traditional gilts beyond 2051 this quarter. (There will likely be an index-linked syndication in November to partially replace a huge at least £24 billion redemption of the 1.875% 2022 linker, which matures on November 22). The DMO has already skewed the issuance to short and medium gilts. While the overall supply of government bonds is definitely increasing, there is some structural demand to be comfortable with when market volatility subsides.
If gilt yields remain at current levels, the BOE will most likely post a gain on its recent efforts and may even be asked to dump some of its longer-dated holdings back into the gilt market to prevent a sudden shortage of certain securities topics asked. This is exactly the opposite of the last three weeks. That future easing could be part of its active quantitative tightening selling program, which it had to postpone when the turmoil hit. It is most likely split to make it clear that the recent financial stability measures were not renewed QE at all, although they look remarkably similar.
This scenario looks prematurely rosy if the gilt market is caught in a decidedly unflattering position. But let’s see if luck is for the BOE. As Dwight Eisenhower said, “I’d rather have a happy general than a smart general.” They win battles.”
More from the Bloomberg Opinion:
The BOE needs to renew, expand and cancel: Marcus Ashworth
Britannia abandons tax rules and wipes out sterling assets: Mark Gilbert
British restraint means knowing when to shut up: John Authers
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Markets Strategist at Haitong Securities in London.
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