Pension fund panic led to emergency Bank of England intervention: Here's what you need to know

Pension fund panic led to emergency Bank of England intervention: Here’s what you need to know

The Bank of England on Wednesday launched a historic intervention in the UK bond market to shore up financial stability as markets were in disarray following fiscal policy announcements from the new government.

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LONDON — The Bank of England has launched a historic intervention to stabilize Britain’s economy, announcing a two-week buying program of long-term bonds and postponing its planned gilt sales until the end of October.

The move came after a sell-off in UK government bonds – known as ‘gilts’ – following fiscal policy announcements from the new government on Friday. The policies included sweeping swathes of unfunded tax cuts that drew global criticism, and also saw the pound fall to a historic low against the dollar on Monday.

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The decision was made by the bank’s financial policy committee, which is primarily responsible for ensuring financial stability, rather than its monetary policy committee.

To avoid “an unwarranted tightening of financing conditions and a reduction in the flow of credit to the real economy,” the FPC said it would buy gilts at “any scale necessary” for a limited time.

At the heart of the Bank’s extraordinary announcement was panic among pension funds, with some of the bonds held within them losing around half their value in a matter of days.

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In some cases, the fall has been so steep that pension funds have started receiving margin calls – a request from brokers to increase an account’s equity when its value falls below the amount required by the broker.

Long-term bonds make up around two-thirds of Britain’s roughly £1.5trillion in so-called liability-driven investment funds, which are heavily leveraged and often use gilts as collateral to raise funds.

These LDIs belong to final salary pension schemes, which were at risk of bankruptcy as the LDIs were forced to sell more gilts, driving down prices and sending the value of their assets below that of their liabilities. Final salary or defined benefit pension plans are popular workplace pension plans in the UK that provide a guaranteed annual income for life upon retirement based on the worker’s final or average salary.

In its long-term emergency purchase of gilts, the Bank of England intends to support gilt prices and allow LDIs to manage the sale of these assets and the revaluation of gilts in a more orderly way, in order to avoid a capitulation. of the market.

The Bank announced that it would start buying up to £5bn of long-term gilts (those with a maturity of more than 20 years) on the secondary market from Wednesday until October 14.

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Expected losses, which could eventually bring gilt prices back to pre-intervention levels, but in a less chaotic manner, will be “fully compensated” by the UK Treasury.

The Bank stuck to its target of £80bn in gilt sales a year and postponed the start of Monday gilt selling – or quantitative tightening – until the end of October. However, some economists believe this is unlikely.

“There is clearly a financial stability aspect to the BoE’s decision, but also a funding aspect. The BoE probably won’t say this explicitly, but the mini-budget added £62bn of gilt issuance this fiscal year, and the BoE’s increased stockpiling of gilts goes a long way to easing funding angst in gilt markets,” ING economists Antoine Bouvet, James Smith and Chris Turner explained in a note on Wednesday.

“Once QT restarts, these fears will resurface. It would probably be much better if the BoE committed to buying bonds for a period longer than the announced two weeks, and suspending QT for even longer.”

A central narrative emerging from the UK’s precarious economic position is the apparent tension between a government easing fiscal policy while the central bank tightens in an attempt to contain sky-high inflation.

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“Bringing back bond purchases in the name of market functioning is potentially warranted; however, this policy action also raises the specter of monetary financing which can add to market sensitivity and force a change in approach,” said Robert Gilhooly. , senior economist at Abrn.

“The Bank of England remains in a very difficult situation. The motivation to ‘bend’ the yield curve may have some merit, but it reinforces the importance of short-term tightening to guard against accusations of dominance. budgetary.”

Monetary financing refers to a central bank that directly finances government spending, while fiscal dominance occurs when a central bank uses its monetary policy powers to support government assets, keeping interest rates low in order to reduce the cost of servicing sovereign debt.

Additional action?

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

Analysts are hoping further intervention from Westminster or the City of London will help ease market concerns, but until then the choppy waters are likely to persist.

Dean Turner, euro zone chief and UK economist at UBS Global Wealth Management, said investors should watch the Bank of England’s stance on interest rates in the coming days.

The Monetary Policy Committee has so far not seen fit to intervene on interest rates before its next meeting scheduled for November 3, but the Bank of England’s chief economist, Huw Pill, has suggested that a “significant” fiscal event and a “significant” fall in sterling will require a “significant” movement in interest rates.

UBS doesn’t expect the Bank to budge on this, but is now forecasting a 75 basis point interest rate hike at the November meeting, but Turner said the risks are now tilted more towards 100 basis points. The market is now expecting a bigger rise of between 125 and 150 basis points.

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“The second thing to watch will be changes in government stance. We should have no doubt that the current market moves are the result of a fiscal event, not a monetary one. Monetary policy is trying to mop up after the milk was overthrown,” Turner said.

The Treasury promised a further update on the government’s growth plan, including costs, on Nov. 23, but Turner said there was now “every chance” it would be brought forward or at least preceded by new announcements.

“If the Chancellor can convince investors, especially foreign investors, that his plans are credible, then the current volatility should subside. Anything less, and there will likely be more turbulence for the gilt market and the pound in the coming months. weeks to come,” he added. he added.

Now what about sterling and gilts?

Following the Bank’s intervention in the bond market, ING economists expect a little more stability in the pound sterling, but note that market conditions remain “febrile”.

“The strong dollar and doubts over UK debt sustainability will mean GBP/USD will struggle to sustain rallies in the 1.08/1.09 area,” they said in Wednesday’s note.

That proved the case on Thursday morning as the pound fell 1% against the greenback to trade at around $1.078.

Bethany Payne, global bond portfolio manager at Janus Henderson, said the intervention was “just a band-aid to a much larger problem”. She suggested the market would have benefited from the government “blinking first” to the market’s reaction to its policy agenda, rather than the central bank.

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“With the Bank of England buying long-term bonds, and therefore showing a willingness to reinitiate quantitative easing when markets get jittery, this should reassure investors that there is a safety net on the market. return on gilts,” Payne said.

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

“However, raising the Bank Rate while engaging in near-term quantitative easing is an extraordinary political quagmire to navigate, and potentially indicates continued currency weakness and continued volatility.”

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