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Friday, December 2, 2022

The Unrest on the Bond Market in the United Kingdom Returns

WorldThe Unrest on the Bond Market in the United Kingdom Returns

The British financial markets fell into upheaval on Wednesday as a result of contradictory signals over whether the Bank of England would continue to assist pension funds and other investors. This came after a botched policy announcement by the new government last month stunned investors.

British government bonds were rapidly sold off in response to the uncertainty. On Wednesday, the yield on the 30-year government bond, or “gilt,” increased by more than 0.2 percentage points, a significant increase for an asset that typically fluctuates by tenths of a percentage point. The yield surpassed 5% for the second time in a month, continuing a sell-off that has pushed its yield from 3% at the beginning of September to approximately where it began the trading day. Bond yields increase when bond prices fall.

The immediate reason of Wednesday’s decline was the Bank of England’s reiteration of its intention to end its bond-buying programme on Friday. Investors are concerned that the central bank is pulling out of the market too quickly, before the market and policymakers fully comprehend the reasons of last month’s first sell-off.

The scenario grew murkier as The Financial Times reported that the Bank of England informed market players that it may continue its intervention beyond Friday. The central bank refuted the claim.

The instability began a month ago when the administration headed by the new prime minister, Liz Truss, revealed a plan to stimulate the economy that included tax cuts and a ceiling on energy costs. The idea to decrease taxes has since been dropped, but it prompted market panic as investors fretted about how the government would finance its new initiatives. This triggered a domino effect in the markets, which reverberated through the pension fund sector and ultimately compelled the central bank to act.

Initially, investors were apprehensive that the government would have to borrow a substantial amount of money to implement its strategy. These concerns caused bond prices to plummet, and yields, which represent the cost of borrowing for the government, increased.

This sharp increase in yields jolted a slumbering segment of the British pension fund sector that is especially sensitive to fluctuations in interest rates and government bond yields. And these alterations have an impact on the future payout obligations of so-called defined benefit pension schemes.

To hedge against fluctuations in interest rates, pension funds use derivatives, which are sophisticated financial contracts. These derivatives get their value from gilts. The first sell-off of gilts in September, in reaction to the government’s promise for tax cuts, was so rapid and severe that the value of the hedges sank. Due to the nature of the derivatives, the decline in their value prompted market players on the opposite side of the contracts to want more collateral to cover the losses.

Pension fund managers, caught off guard by the swiftness of the move, started selling other assets, including gilts, to acquire the cash required to pay the collateral requests. These sales merely worsened the situation, causing gilt prices to fall further.

The sell-off caused the Bank of England to initiate a short-term programme to purchase gilts on September 28 to stabilise the bond market. At the moment, the central bank said that it will end its purchases on Friday, giving pension funds sufficient time to get the necessary collateral and stabilise themselves.

Nevertheless, the pension fund sector is often sluggish, and the sale of assets and transfer of funds for security may be time-consuming. As of the previous week, several asset managers reported that pension fund customers were still withdrawing money out of their funds in order to generate additional cash.

The Bank of England announced on Monday further assistance measures, including the purchase of inflation-linked bonds and a temporary facility that would give banks with short-term loans in return for government bonds.

As of Tuesday, the central bank has spent around 7 billion pounds on bond purchases, which was far less than the possible £65 billion made available for the duration of the programme. In addition to spending about £2 billion on inflation-linked bond purchases, the central bank said on Monday that it will acquire up to £5 billion every day for the remainder of the week.

Andrew Bailey, the president of the central bank, said on Tuesday that the original deadline of Friday would stay in place, informing pension funds they had “three days remaining.”

However, as soon as the central bank reaffirmed its intention to withdraw from the market on Friday, 30-year gilt rates climbed back over 5%, setting the stage for a turbulent conclusion to the week.

Part of the difficulty for the central bank is that its short-term bond-buying programme — which it implemented to soothe markets after the Truss administration’s intentions alarmed investors — conflicts with its longer-term attempts to unwind pandemic-era asset purchases and boost interest rates. Similar to other central banks, the objectives are to calm the economy and reduce inflation.

Now, the government and the Bank of England are somewhat at odds; but, clarity will emerge by the end of October, when the government will provide more information on how it plans to pay for its new initiatives.

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