How the Bank of England is scrambling to stabilise markets

The Bank of England performed a dramatic U-turn this morning, putting the brakes on its plan to sell Government bonds and launching a new scheme to buy gilts instead.

Officials on the Financial Policy Committee, led by Andrew Bailey, the Governor, are seeking to push down the Government’s borrowing costs after a sharp spike in interest rate predictions in financial markets.

Interest rates are rising across the world, but investors were spooked by Kwasi Kwarteng’s mini-budget last week which set out plans for significant tax cuts on top of the unlimited cost of the energy support package, indicating a steep rise in borrowing is on the way.

What is the Bank doing?

As with quantitative easing, the Bank is creating reserves — crudely put, a form of digital money printing — and using it to buy bonds which were issued by the Government when it needed to borrow money.

It is specifically choosing long-dated gilts, bonds issued when the Treasury wanted to borrow for 20 years or more.

The scale has not yet been decided. The FPC says “the purchases will be carried out on whatever scale is necessary” to “restore orderly market conditions”.

When bond prices fall, it means the interest rate faced by the Government rises.

This happened because the Government announced plans to borrow more money, meaning it will issue more bonds, known as gilts.

The sharp rise in the supply of gilts was not matched by demand from the investors who buy bonds.

As a result the price dropped, and the interest rate rose.

By stepping in, the Bank of England has become a big new buyer of bonds, adding to demand in the market, meaning there is more competition among buyers. This extra demand pushes the price up, and reduces the borrowing cost again.

The Bank has also delayed the start of its programme of selling bonds. Last week the Monetary Policy Committee launched active quantitative tightening, a plan to cut its holdings of bonds, bought under years of quantitative easing, by £80bn over 12 months. Around half of that would be active sales, with the rest simply allowing bonds to mature and roll off its books.

Long-dated bonds are an important part of those sales, so buying and selling at the same time would make no sense.

Why is it doing it?

It is not the Bank’s job simply to intervene when investors ditch bonds and so the Government’s cost of borrowing rises.

That is merely the market responding to investors’ view of the risks of lending to the British state, the effect of predicted inflation on their money, the competition on offer in global markets, and a range of other factors affecting decisions on where to put their cash.

Instead, the Bank is citing “dysfunction” in the markets.

This has been left undefined, but is thought to relate to the impact of plunging bond prices — and rising yields — on pension funds.

These funds have to hold long-term assets to reflect the long-term horizons of their savers, putting money away for their old age.

But when bonds plunge, the funds face margin calls demanding they put up more cash. That forces them to sell bonds, in turn driving further falls in prices, in a self-fulfilling cycle of losses.

The Bank’s intervention is an effort to break that cycle.

As former pensions minister Baroness Altmann puts it, pension funds had become victims of "reckless conservatism" having been encouraged to park much of their cash into gilts by regulators.

This has meant that as gilt prices plunge and yields surge higher, the funds have faced sudden cash calls from banks who are trying to contain their losses. Whereas usually the funds might have weeks to find the money, they are now being given just days.

Lady Altmann added: "The regulators were saying don't touch risky assets, try and focus on so-called low-risk gilts, as if the market was a free market. Well, it hasn't been a free market for a long time. And what you're seeing now is another distortion.

"Pension funds are saying they are in desperate trouble, because they're getting these cash calls. They have to sell assets to meet those cash calls. And that takes away the future returns and it doesn't deliver them anything. They're just covering losses on assets that were meant to be safe.

"Now the Bank is coming in, trying to buy up gilts to try and force the price down again. How will that play out? We don't know. But certainly, for the Bank of England to be doing this suggests there really is a big emergency. This is not something they would do lightly."

Will it work?

Markets responded instantly. The Government’s 10-year borrowing costs dropped from almost 4.6pc to just below 4.2pc. Its 30-year interest rate fell from just over 5pc to under 4.5pc.

The pound yo-yoed as traders digested the implications for interest rates, financial stability and the UK’s growth outlook.

In the longer-term — which in this case is measured in a matter of weeks — it gives the Government momentary breathing space to try to get a grip on the situation.

A Treasury spokesman said “These purchases will be strictly time limited, and completed in the next two weeks”.

The Bank’s statement gave a subtly different message, not guaranteeing that the purchases will end so soon.

The initial plan is to buy bonds over two weeks, but the Old Lady also said “the purchases will be carried out on whatever scale is necessary to effect this outcome” while “the purchases will be unwound in a smooth and orderly fashion once risks to market functioning are judged to have subsided”. That is a little more open-ended.

What are the dangers?

The scheme is not without risk.

The Bank of England has “operational independence”, meaning the Government sets its goals — get inflation to 2pc, maintain financial stability — but the Bank can choose how to get there.

Its job is not to finance the Government’s vast borrowing plans. Spending and borrowing plans are meant to be taken into account insofar as they affect growth and inflation, but quantitative easing — or tightening — is meant to be carried out with the aim of hitting the inflation target.

Buying more bonds, even on a “strictly time limited” basis to “tackle a specific problem in the long-dated government bond market” raises the risk of giving the appearance the Bank has to buy bonds when the Government wants to borrow more.