Gilts: BoE helps LDI funds rappel off the cliff

When is monetary policy not monetary policy? When there is a crisis, it seems.

The Bank of England recently repurchased gilts for reasons of financial stability rather than quantitative easing. Further calming measures were presented on Monday. This should mean that the gilt market is even less likely to fall off a cliff amid more panic selling after the Treasury program ended on Friday.

The bank has so far only bought around £5bn worth of gilts out of a possible total of £65bn. This suggests that pension funds’ dangerous exposure to liability-driven investments is lower than first thought.

The UK central bank is still taking no chances. It will allow for larger buying this week and introduce additional liquidity backstops. Nobody interprets this as a weaker commitment to fighting inflation, which is crucial to the UK’s long-term financial health.

The BoE doubles its maximum daily gilt purchases to £10bn for the rest of the week. It creates a new liquidity system for banks with clients using LDI that includes a derivative hedge against low interest rates. Rising interest rates have recently triggered costly and destabilizing margin calls.

Wobbly pension funds can park government bonds and investment-grade corporate bonds for cash. Unlike gilt purchases, use of the facilities will be off-balance sheet for the BoE, says Capital Economics’ Paul Dales.

30-year gilt yields rose to just over 4.5 percent on Monday, staying below levels seen during the panic. They have been marching higher since the start of the BoE intervention. Steadily lower British bond prices would strengthen the bank’s credibility.

Encouragingly, the UK bond market is forecasting long-term inflation in line with the US and Europe. But the bank has yet to start quantitative tightening.

Long gilts are unlikely to be part of these operations for now. Fortunately, the longest-dated gilts account for only about a tenth of the BoE’s £800bn in gilt holdings. There’s plenty of room for the bank to deliver on its promise of a smaller balance sheet.

The Lex team is interested in hearing more from readers. Please let us know what you think of the recent BoE action in the comments below.