BoE’s limited window could punish the gilt-y

Dan Barnes

The Bank of England’s limited UK government bond (gilt) purchase operations have been confirmed to close on Friday, putting tight brackets around buy-side firms’ use of this liquidity backstop to help manage risks faced by liability-driven investment (LDI) strategies.

On Monday the BoE increased its asset purchasing of long-dated gilts to include index-linked government bonds to “enable LDI funds to address risks to their resilience from volatility in the long-dated gilt market,” after a 63 basis point sell-off in 30 year index-linked gilts.

The Bank said, “LDI funds have made substantial progress in doing so over the past week. However, the beginning of this week has seen a further significant repricing of UK government debt, particularly index-linked gilts. Dysfunction in this market, and the prospect of self-reinforcing ‘fire sale’ dynamics pose a material risk to UK financial stability.”

The expansion of the programme was set to run until 14 October with up to £10 billion of gilts being bought on a daily basis – albeit with the BoE setting limits on yield/price – split across conventional and index-linked gilts.

This had some calming effects on the exchange rate between dollar and sterling (cable) as well as on parts of the bond market. However, last night Andrew Bailey, government of the BoE, announced he would not be offering open-ended liquidity support.

As analyst note from Morgan Stanley explained; “Shortly before 3:00pm ET, BoE Governor Bailey acknowledged that monetary policy was now operating in contrasting directions. He continued by confirming the BoE ‘will be out’ of the market by the end of this week. He communicated a clear message there are ‘three days left now’ for funds to conduct rebalancing activity with the backstop provided by the BoE.”

The effect was negative across the board as the MS team observed.

“Risk sentiment deteriorated quickly as the S&P 500 (-0.65%) cascaded lower to briefly test the 3,570 level. GBP reversed its prior strength, weakened on a broad basis, and finished the session as one of the underperformers in G10 FX. GBP/USD slid 1.5% into the NY close and settled -0.8% d/d at 1.097. With gilt markets already closed for the Tuesday session, US Treasuries perhaps traded in anticipation of a further steepening in the gilt curve on Wednesday. The US Treasury curve twist-steepened, led by 30y US yields which rose 8.1bp d/d to close at 3.92%.”

For LDI pension fund operators, this fixed window of additional liquidity makes them forced sellers which could create a ‘Woodford effect’, leaving the least liquid assets within portfolios as buyers cherry pick the best buys.