Overnight, cable rose and then fell well over 200 pips, then jumped over 100 pips before the market opened. That’s typically a time when the pound is relatively quiet, with European markets closed. Comments from BOE’s Bailey and press speculation about bond buying have been pushing this price action, so let’s delve into the details.
It just doesn’t end…
The latest moves in the pound are part of the continuing saga of the “mini-budget”, which promised to cut taxes and increase government spending to halt the rise in oil prices. Because the Chancellor has yet to explain how this program is going to be financed, the assumption is that the UK will have to take on substantially more debt. This, in turn, has pushed interest rates higher on the far end of the curve, as investors are worried about the government’s financial stability.
Pension funds ran into a problem here, because the sell off in long term gilts put them into insolvency risk. Pension funds hedge against volatility in the derivative markets by putting up long-term UK debt as collateral in securities called LDIs. How they work in detail isn’t especially important. What is important is that if bonds are being sold, the market valuation of those bonds drops. Which means that pension funds would have to put up more collateral or face margin calls on their hedging contracts.
The “doom spiral”
If pension funds were forced to sell their bonds because bond prices were falling, it could cause a downward spiral in the bond market. Each fund that had to sell bonds would push the price further down forcing more funds to sell their bonds. Pension funds hold over £1.0T in bonds. That’s why the BOE stepped in on Sept 28, offering to buy up bonds, and force the price up (and the yield down).
The thing is, since then, the BOE has offered to buy up to £40B in bonds, but only £5B have been tendered. The BOE wanted their intervention in the market to be “temporary” and have promised to buy bonds only until this Friday. Pension funds have been pushing for the BOE to keep the facility open for longer. But last night BOE Governor Bailey insisted that the bond buying facility would be shuttered as planned, and on top of that, said that pension funds have only 3 more days to get their affairs in order.
Why the harsh tone?
Although Bailey didn’t say it explicitly, that pension funds haven’t taken up the BOE’s offer to buy bonds appears to be irking policymakers. The funds are keeping their (in the current circumstances) high risk investments in place, insisting that the BOE take on the “moral hazard” of backstopping them if the bond market drops further. Bailey’s comments could be understood as pushing pension funds to take losses in order to secure their fund positions.
The standoff between the funds and Bailey saw the pound fall substantially. Overnight, the FT reported that bankers had been privately assured that the BOE would keep supporting pension funds by buying bonds. Without confirmation from the BOE itself, that doesn’t provide enough assurance to redirect the market. But it appears to have at least slowed the fall.
The next step is to see whether BOE officials come out to confirm the FT report, or deny it. That could provide the next round of uncertainty to the markets. Meanwhile, we’ll just have to wait until November 23, when Kwarteng finally provides the key bit of information that could calm (or shake up) the markets: How the spending plan will be financed.
