The writer is global head of fixed income research at HSBC
British government bond yields have been trading at their highest levels since the global financial crisis and their volatility has made them hard to trade. This is not because there are serious questions about the creditworthiness of the UK government.
Rather, it is because fundamental and technical factors have combined in such a way to cause the market to malfunction, leading to forced sales and sharp price falls. Can the gilt market be repaired?
Already, the Bank of England has stepped in to provide some stability by buying gilts. This reflects the reality that there are real-life implications from bond market dislocation. Sharp volatility, in what is normally a stable corner of the financial markets, could spill over into the real economy. This can come in the form of higher borrowing costs and knock-on effects on sentiment.
Central banks have acted as buyers of last resort many times before in such moments. A recent example is March 2020, when the US Federal Reserve had to buy a huge amount of bonds to help dealers stuck with illiquid Treasury bonds nobody wanted. They didn’t do this as a favour for the banks and the dealing rooms. It was because of the potential ramifications for the real economy.
The point of this is that there are real people in the real world who have savings and mortgages. Many have a large proportion of their wealth stored in pensions and houses. All of this will be directly affected by what’s happening in the UK gilt market unless steps are taken to calm things down. Most of the population won’t own gilts, and if a fund manager holds them on their behalf, they may not even know it.
Then there is the impact on consumer confidence and how this feeds back into the economic data. Already dealing with high energy prices, the last thing UK households need is a sharp increase in mortgage rates. Faced with the anticipation of a drop in disposable income and an economic downturn, people change their behaviour. They become more risk-averse, less risk-seeking.
So is the Bank of England’s intervention enough? It may be that further steps have to be taken to calm the gilt markets down. As well as further central bank action, there may need to be adjustments by the Debt Management Office, which sells the bonds on behalf of the British government. Here are four possible next steps.
First, shift issuance to shorter-dated maturities to ease supply pressures. As an issuer, the UK government currently has the highest average maturity of any government bond market. At 13.5 years this is almost double the US Treasury market and much more than the eurozone. Granted, there is a lot of debt to be financed, but locking British taxpayers into extremely high rates by recent standards would be far from ideal.
Second, intervention in the market for longer-term gilts may need to be open-ended. An interesting step was just taken with the announcement that bonds that have returns linked to the inflation rate will be included in the gilt purchases. Previously, unlike other central banks, the Bank had not included the “linkers” in its quantitative easing programme of bond buying for fear of distorting the market. Now they need to buy them as the greatest selling pressure is coming from pension schemes.
By including a wider range of bonds, the actions appear broader and can signal to markets that the BoE will continue to be active until markets stabilise. It makes sense to the British taxpayer, too, when the central bank, acting on its behalf, buys a safe asset at 10 per cent when the Bank’s benchmark policy rate is 2.25 per cent.
Third, the Bank of England could restructure quantitative tightening, the reversal of QE. Active quantitative tightening has been long planned, but has already been postponed as circumstances have changed. It remains desirable for the Bank to reduce the size of its balance sheet, but it may now make sense to concentrate sales on bonds with shorter terms. Indeed, we see no reason why it is not possible for a backstop at the “long end” to exist while active quantitative tightening is taking place at the “front end” of the yield curve.
Fourth, and to be consistent with the other three proposals, signalling on the path of interest rates may need to be reconsidered. Markets have been implying at least another 1 percentage point of hikes in the Bank’s policy rate. But if recent developments have increased the probability of recession, then rates may not have to go as high as previously projected. A quick fix is unlikely to be enough.