Why did the Bank of England say it would purchase government bonds, just a week after announcing a plan to sell them?
The central bank said it acted on financial-stability grounds. And it targeted support at the long end of the maturity curve. “Were dysfunction in this market to continue or worsen, there would be a material risk to U.K. financial stability. This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy,” the Bank of England said.
The Bank of England didn’t delve into details. But the focus on the long end — it’s only buying bonds with maturities of at least 20 years — points to two particular problems.
The first has to do with pension funds. They’re not by nature wild speculators. But they are big users of both interest-rate derivatives and swaps. A report from a pension regulator said about two-thirds of the top 600 U.K. pension funds were users of interest-rate swaps. The publication Risk said some were hit with margin calls of as much as £100 million due to the dive in both gilts as well as sterling.
It’s also worth noting what pension funds use as collateral on these derivatives positions — gilts. So a margin call forces them to sell gilts, to cover losses that ultimately stemmed from the decline in gilts.
The Bank of England’s actions had immediate results, with the yield on the 30-year gilt
diving more than 100 basis points.
“This probably reduces the tail risk of endless stop outs causing real yields to continue spiralling higher,” said Orla Garvey, senior fixed income portfolio manager at Federated Hermes.
The second issue generated more headlines in U.K. media. Mortgage providers were withdrawing products en masse. They, too, are big users of interest-rate swaps. Those swap rates, in turn, were affected by the swings in the gilt market.
The issue over mortgages is not immediately quelled, however. Mortgage rates in the U.K. are tied more to the short end of the curve, which in turn is very sensitive to Bank of England-set interest rates. Markets are currently pricing in a rate hike on the order of a full two percentage points at the November meeting, and that rates will peak at 6%.
“A policy rate near 6% would see average mortgage payments rise over 50% from the levels of a year ago. This would be an unprecedented hit to household incomes, on top of the squeeze that businesses and consumers are already seeing from the surge in energy prices, and would all but ensure a deep recession,” said strategists at Barclays.