A double gilt-edged sword

The Bank of England has now had to step in to stabilise financial markets after the pound plunged against the dollar, causing UK borrowing costs to soar this week. The UK Government which deficit finances i.e. raise funds by issuing promissory notes or bonds that investors buy in the international financial markets, now plan to spend 65 billion pounds buying back British bonds by mid-October. 

Market participants believe concerns about the impact of these changes on pension funds is what prompted action. Bank officials however, said they were effectively lending money to the Government to lower interest rates on Government bonds. The measures have been characterised as temporary and targeted, but have already lowered the UK Government’s borrowing costs.

Concerned that financial market panic is pushing up borrowing costs in the UK at an alarming rate, the Central Bank hoped the announcement of its intention to intervene would instil calm. Stability in bond markets is also expected to have an effect on the pound. The market reacted negatively to the tax cuts, with many analysts saying it would not improve the UK’s long-term growth prospects and would add an unwarranted amount of stress to an already huge and growing pile of debt. 

But when bond yields rose sharply, derivative contracts required pension funds to post more collateral. After exhausting existing cash reserves, the fund sold bonds to meet its commitments. This puts more selling pressure on bond rates and exacerbates the doom loop when other bonds are also trying to sell.

Many pension plans use so-called “liability-driven investment” (LDI) schemes to hedge against sudden interest rate movements. Up to 1 trillion pounds are believed to have been invested in such LDI schemes. For security, the buyer will post collateral and then this is the asset that the seller accepts as collateral for the transaction. For the LDI program, these were UK Government bonds with long maturities up to 30 years.

Bank intervention helps buy time for pension funds to unwind their derivative positions. As the UK Government issues bonds for 2.2 trillion, the interest rates on long-term loans have doubled for it in recent weeks. This debt is packaged as bonds and sold and resold on international markets. Anyone can buy UK Government bonds and many market participants indirectly hold them in pension funds. 

In fact, they lend money to the Government by buying British bonds. When they enter the market to buy bonds, these new buyers bid up the price at a the higher the value. A higher value tells other potential buyers that buying the bonds are now less risky, lowering interest rates. 

In UK Banks now holds 875 billion pounds worth of UK Government bonds. This means that the UK Treasury pays interest to the Central Bank and other banks. Banks create money backed by the Treasury instead of paying cash for bonds. That means every pound is actually covered by the taxpayer. 

Financial markets understand that only a small fraction of bonds will mature, accepting Government guarantees as if they were gold-plated or ‘gilt edge’, as it was called in the olden days. The bank calls its bond-buying program quantitative easing. They intended to reverse the process and start putting selling pressure on British bonds. 

Certain currencies such as the dollar, euro, Japanese yen, and British pound are all widely traded and used to purchase goods and services around the world, making them reserve currencies. International authorities become concerned when one of them begins to depreciate and become unstable, as the pound has fallen recently. 

This is one of the reasons why the International Monetary Fund has expressed concern over the UK Government’s 45 billion pound tax cut. The Washington-based IMF has accused Britain of acting as a lender of last resort to countries unable to finance their debts and destabilising global financial markets. They were also concerned about rising inequality, which has been shown to reduce productivity.