Why Bank of England bought gilts a week after announcing sale

Why Bank of England bought gilts a week after announcing sale

Why did the Bank of England say it would purchase government bonds a week after announcing a plan to sell them?

The central bank said it acted on financial-stability grounds. It wanted to support at the long end of the maturity curve. Were dysfunction in this market to continue or worsen, there would be a significant risk to U.K. financial stability. The Bank of England said that 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 didn't delve into details. The focus on the long end - it only buys bonds with maturities of at least 20 years - points to two particular problems.

The first has to do with pension funds. They are not wild speculators by nature. 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 that some of the publications had been hit with margin calls of as much as 100 million due to the dive in both gilts and sterling.

It is worth noting what pension funds use as collateral on these derivatives positions. A margin call forces them to sell gilts to cover losses that stemmed from the decline in gilts.

The Bank of England's actions had immediate results, with the yield on the 30 year gilt TMBMKGB-30 Y falling more than 100 basis points.

According to Orla Garvey, senior fixed income portfolio manager at Federated Hermes, "This probably reduces the tail risk of endless stop outs causing real yields to spiral higher."

The second issue generated more headlines in the U.K. media. They are big users of interest-rate swaps. The swings in the gilt market affected the swap rates.

The issue over mortgages is not immediately resolvable. Mortgage rates in the U.K. are tied more to the short end of the curve, which is very sensitive to Bank of England-set interest rates. Markets are 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 businesses and consumers are already seeing from the surge in energy prices, and would cause a deep recession, according to strategists at Barclays.