Cliff Edge looms for UK financial system | bank of england

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The British financial system is on the brink. After stepping in to calm the market chaos that followed Kwasi Kwarteng’s mini-budget, the Bank of England insisted it would close the £65billion emergency program used to iron out the mess .

From Friday, the central bank plans to suspend its bailout purchases of British government bonds, in a market where funds managing the retirement savings of pensioners across the country are still at risk of being dangerously burned.

It’s a big gamble, to say the least, given the scale of the financial, economic and political difficulties in which Britain finds itself.

“The good result is that the government and the Bank seek to regain the confidence of investors and successfully regain it. At the moment, we are moving away from that a bit,” said a city fund manager.

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It comes in a critical week when Kwarteng and Bank Governor Andrew Bailey are out of the country at the International Monetary Fund’s annual meetings in Washington. Tensions were already running high before the unrest began, after Liz Truss used the Tory leadership race to cast a shadow over the Bank’s inflation-fighting record.

Arriving for the meeting of the world’s finance ministers and central bankers – at which the collapse of Britain’s mini-budget has become a central part of the show – Kwarteng was asked his thoughts on the end of the bond-buying rescue program this Friday.

It was a Bank decision, he said. But there are risks for both men in the crisis; in which government, the Bank, the financial sector and global economic trends have all played a role.

Kwarteng’s mini-budget is widely seen as the trigger that sparked a ‘catastrophic loop’ in bond markets last month as pension funds dived into complex derivatives they had bought to hedge against the rise in interest rates.

Schemes responsible for pensioners’ money across the UK had invested more than £1 billion in so-called Responsibility Driven Investing (LDI) funds. The schemes in question are the gold-plated defined benefit pension schemes, where the employer has committed itself to a fixed level of pension each year, regardless of the performance of the fund.

Many have used hedging agreements to hedge against shortfalls. Repos are among the biggest buyers of government bonds, and when the value of those bonds fell, they faced demands for additional cash to cover hedges. To raise this cash, they sold government bonds, further depressing the value of these assets, forcing them to sell more bonds.

In the four days since Kwarteng’s ill-fated speech – before the Bank’s emergency intervention – 30-year bond yields rose more than the annual increase in 23 of the past 27 years. Some funds have come close to the point of collapse.

The moves come as interest rates in advanced economies rise, as major central banks around the world raise borrowing costs to combat runaway inflation triggered by Russia’s war in Ukraine.

“What the government has managed to do is take a general rise in global interest rates and face up to its bad policy choices,” a City banker said.

Economists warn that Britain’s credibility is at stake for two things in particular: the management of sound public finances and the fight against inflation. “This is causing a strike by UK asset buyers,” said Deutsche Bank’s George Saravelos.

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While the central bank has the headache of trying to bring down inflation to its highest level since the 1980s, the emergency bond purchase program is aimed squarely at tackling stability risks financial. Investors see the ultimate cause of the tumult in the government’s “ill-calibrated” fiscal plans, Saravelos added.

Despite this, the Bank has used less than a fifth of its potential £65bn intervention, buying less than £10bn of UK government bonds since its intervention on September 28.

In a bid to ensure the program ends as planned this week, the Bank stepped up its firepower to intervene by promising to buy up to £10bn worth of bonds a day. He also started buying index-linked gilts, securities whose interest rates rise and fall with inflation. After the end of its main bond buying program, it announced that there would be a loan program to support the markets.

Pension funds are expected to heed the Bank’s calls to bolster their finances ahead of Friday’s cliff edge, selling more bonds to raise the tens of billions of pounds in cash reserves that Threadneedle Street believe they will need. The objective will be to create reserves large enough to protect against any future rapid movements in the bond markets once the Bank pulls back.

However, some investors doubt that the turbulence can be avoided entirely. Big questions remain about the scale of the government’s borrowing plans – and therefore likely moves in bond markets to accommodate them – before Kwarteng announces its debt reduction strategy on October 31.

The Bank also plans to start selling UK government bonds on the same day as it tries to exit its quantitative easing program with sales of 80 billion pounds expected.

This strategy is seen as vital to fighting inflation, and Threadneedle Street will only reluctantly abandon it.

Something has to give.

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Don F. Davis