UK Reaction: Bank of England steps in to quell government-inspired market turmoil
• The Bank of England steps in to buy the long-end of the gilt market to address “dysfunction”.
• Operations will last from 28 September to 14 October and will be financed with central bank reserves.
• The operation marks the first concrete action to address the disruption of UK asset markets caused by Chancellor Kwarteng’s fiscal announcement last week.
• Market reaction has been sharp, with yields falling sharply, but the implications have seen sterling come under more pressure.
• The Bank has stated that these operations will be “strictly time limited”.
• We suspect this buys time for the government to “re-evaluate” policy – as the IMF urged – overnight.
• The Conservative Party Conference from the weekend will provide the opportunity for the government to adjust course, but whether it takes this opportunity will determine the next stage of the UK’s current crisis.
On Day 6 of the UK’s economic crisis, the Bank of England (BoE) has announced the first concrete operations to address the disruption in the UK gilt market caused by the Chancellor’s fiscal announcement last week. The Bank will buy long-end bonds to address market “dysfunction”. It stressed that this was a “strictly time limited operation”. We suggest this buys time for the government to announce some reversal of recent policy announcements. The upcoming Conservative Party Conference provides the next test as to whether the government will react. Otherwise, UK asset markets are likely to come under further pressure.
After the collapse in sterling and surge in UK government bond yields after Friday’s “fiscal event”, Day 6 of the UK’s crisis saw the Bank of England respond to deteriorating conditions with actions more than words.
The BoE announced “temporary purchases of long-dated UK government bonds” from today in order to “restore orderly market conditions”. The Bank’s news release stated that purchases would be carried out “on whatever scale necessary” and will be “fully indemnified by HM Treasury” (the UK tax payer). The BoE’s Financial Policy Committee highlighted the “risks to UK financial stability from dysfunction in the gilt market”, requiring these purchases at “urgent pace”. The release also stated that the purchases would be “strictly time limited” and are intended to “tackle a specific problem in the long-dated government bond market”.
This operation was not monetary policy inspired and as such, the Monetary Policy Committee (MPC) of the BoE was informed of the actions (although in practice several members including Governor Bailey overlap both committees). From a monetary policy perspective, the MPC reiterated that it would make a “full assessment … at its next scheduled meeting”, reiterating that it will set monetary policy to return inflation to its target. However, the Bank stated in its operational notice that purchases would be funded by central bank reserves, effectively expanding the quantitative easing (QE) stock. The MPC stated that it would still reduce the stock of QE by £80 billion this year. However, the first quantitative tightening (QT) auctions will now be deferred from next week to 31 October and the stock of gilts now held will be larger – effectively a monetary policy easing.
The market reaction has been understandably sharp. 10-year gilt yields – we assume not to be directly purchased by the BoE – fell 55 basis points (bps) to 4.01% after the announcement although have drifted higher to 4.10%. 30-year gilts have fallen by 1010bps to 4.05%. The BoE announcement was made after the Debt Management Office’s long syndication today, resulting in a sharp boost in price to bonds bought in this operation. Sterling by contrast, has swung wildly, initially bouncing by 1.4% to the US dollar (1.0% to the euro), before reversing to down 0.9% (1.1%) compared to before the reaction and currently flat in dollar terms and down 0.4% to the euro.
The Bank’s operations today came after days of verbal support. On Monday Governor Andrew Bailey simply said that the Bank would review developments at its next meeting. Yesterday, BoE Chief Economist Huw Pill acknowledged that the government’s actions would require “a significant market response”. Although sterling had stabilised, long-end gilt yields continued to rise and liquidity conditions in gilt markets deteriorate, prompting the Bank’s response. However, today’s announcement is a sticking plaster – purposely identified as such. Although the Bank will continue to ensure the orderly operation of markets, they cannot and do not intend to try to cap longer-term government yields.
This begs the question of what happens next? The Bank hopes to be able to get to its next policy meeting on 3 November. At that time, we have assumed that it will have to raise rates more sharply than to date – we had pencilled in a 75bps hike, but a larger move is plausible depending on market conditions. Interestingly, the BoE’s assessment that moves to date would result in “an unwarranted tightening of financial conditions” raises the prospect that should they persist, the exogenous long-end tightening may require less short-end (i.e. policy) tightening than considered before, despite the technical additional stimulus of QE from these operations. On balance, we think that this adds to arguments for more sterling weakness. Market pricing of short-end rates rose to 6.25% by next May but has retreated back below 6%.
Fundamentally, the BoE is left trying to address a problem not of its making. The necessity of the Bank’s intervention to address the disruption of orderly markets caused by the Chancellor’s statement on Friday (and compounded over the weekend) is quite exceptional. The modestly conciliatory announcements from Chancellor Kwarteng bringing forward an announcement of the medium-term fiscal framework to 23 November, when the Office for Budget Responsibility will finally get a chance to opine, and repetitions of commitments to fiscal sustainability have proven insufficient to quiet broader alarm at the direction of government policy. The International Monetary Fund added to the chorus of disapproval overnight stating that it was “engaged” with UK authorities and urged the government to “re-evaluate” the “large and untargeted fiscal package”. As such, we suggest that UK asset markets are likely to come under persistent pressure until this is addressed head on – with either some suggestion of financing of some of the announced moves – or reversing them. Clearly, the latest government policies to ignore economic realities are politically very damaging, but they are also proving economically damaging. To our minds, the BoE’s operations buy time for the government to “re-evaluate” policy. We suspect that they are designed to do no more and that the BoE has communicated this to the government, hence we believe the phrase in today’s statement that these operations are “strictly time limited”.
With the Conservative Party Conference starting at the weekend, the Chancellor has an opportunity to about-turn. However, refusal to change course is likely to exacerbate the pressures in UK financial markets and increase the longer term economic damage.