“Temporary” and “whatever it takes” don’t go well together.
Even as a law of falling yields suggests that policymakers’ legendary “whatever it takes” warning to markets is easing somewhat, the phrase still draws its power from its simplicity and its open-ended commitment to overwhelming power.
Used most effectively in a financial context 10 years ago by then-European Central Bank chief Mario Draghi, it all but ended the then-raging Eurozone sovereign debt crisis by simply signaling that the ECB would use all available firepower indefinitely, so long as it did took until she was stable the ship.
No taboos, no size or time restrictions.
The circumstances, context and precise wording may be different this week, but the Bank of England mimicked some of that language in Wednesday’s dramatic decision to buy UK government bonds to prevent an implosion in the so-called gilt market.
When market dysfunction risked a doom loop of pension fund cash calls and forced sales on rising yields, grossly exaggerated by the UK government’s tax-cutting fiscal plan last Friday, the bank clearly had to act – albeit reportedly against the boost of its ongoing tightening of monetary policy.
“The purpose of these purchases will be to restore orderly market conditions,” the BoE statement said. “Purchases will be made to any extent necessary to achieve this result.”
Powerful words with echoes of 2012.
Like the ECB 10 years ago – or even this year when it designed an anti-fragmentation tool to limit credit spreads within the euro – the BoE justified Wednesday’s intervention by citing the need for well-functioning markets to adequately transmit its monetary policy .
But unlike the ECB a decade ago, the BoE’s underlying monetary policy is the polar opposite of what it needs to do to calm markets and risks sidelining its campaign to raise interest rates to control inflation. In particular, it is surpassing its commitment to trim its £800bn-plus balance sheet by actively selling £80bn of gilts over the coming year, which is part of its quantitative tightening (QT) promise.
So much so that the BoE was forced to qualify the seemingly forceful “any measure is necessary” line with what Lieutenant Governor Dave Ramsden emphasized on Thursday that the operation would be “strictly time-limited”.
The hope is that it gives pension funds just two weeks to ease liquidity and collateral constraints at the long end of the bond market – and allow the BoE to “smoothly” unwind those purchases again and resume the postponed QT selling next month picking up and delivering what the futures markets are now assuming will be a whopping 1.25 percentage point hike in interest rates on November 3rd.
That’s a hopeful expectation.
GOLDEN JOURNEY
If the problem was just a quarter-end quirk in derivatives hedging, maybe it’s working.
But if the key issue is rising bond yields and swap spreads amid sky-high inflation expectations, rising interest rates, unfunded tax cuts and a falling pound, then by year-end at the latest, it could just be the issue.
“While the Bank of England’s intervention on Wednesday averted a vicious cycle of forced sales that had begun, the underlying risks of high inflation, a weak pound and uncertainty about government budget plans remain,” said Invesco Solutions portfolio manager Derek Steeden.
Steeden said collateral calls are expected as gilt yields rise and most pension schemes have a pre-agreed order of which assets to sell first.
But while the programs have worked up those reserves in recent months as yields have risen, he said the recent surge, which has seen 30-year interest rate swaps rise more than 100 basis points, means they are now well above the gilt market, if nothing else would have to sell as the pressure to “de-risk” funds mounts since the discount rates that drive funding levels are so much higher.
“It’s not over yet – many UK pension funds invest globally but have sterling liabilities and use currency hedging programs to neutralize the effects of currency movements,” he stressed. “These programs have yet to recoup losses from the falling pound.”
Then, if the BoE fails to fully extinguish the fire over the next few weeks, the “limited-time” commitment could become more vague than two weeks – further complicating its monetary policy, in a way chief economist Huw Pill conjured on Thursday would not.
It could even end up in a confusing scenario that HSBC is calling “Operation Twist” where it ends up buying long-dated gilts and selling short-dated paper at the same time, inverting the yield curve even more.
In any case, sterling’s vulnerability will continue to attract speculators who now see myriad policy contradictions.
Hedge funds lick their lips.
John Floyd’s Floyd Capital Management believes that the gilt interventions mean that lower yields will make it difficult to fund the UK’s massive balance of payments deficit and that a weaker currency will only be the balancing mechanism. Veteran trader and family office manager John Taylor was more direct: “It’s never too late to be short sterling.”
Stanley Druckenmiller, who helped Marshal’s billion-pound bet on sterling’s exit from the European Exchange Rate Mechanism in 1992 when he was at Soros Fund Management, doubts the BoE’s plan this week will improve the bigger picture.
“The situation in England is pretty serious because 30% of mortgages are heading towards variable rates,” said Druckenmiller. “What you don’t do is take taxpayer money and buy bonds at 4%. This leads to problems in the long run.”
Unfortunately, time is not on the BoE’s side.
Source: Reuters (by Mike Dolan; reporting added by Nell Mackenzie and Carolina Mandl)
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