UK financial system gets relief across the board

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Mirza Kadic/iStock via Getty Images

By Fredrik Repton


On Wednesday, the Bank of England announced that it was intervening in the gilt market. The central bank said the long end of the gilt curve had become dysfunctional and was a serious risk to financial stability. Longer term gilts will be bought in daily auctions running until October 14th. Moreover, the start of quantitative tightening will be delayed until the end of October.

Given the extraordinary intervention, it is worth taking stock of what prompted the BoE to take such drastic action. Between the time the Chancellor announced the UK’s ‘mini budget’ last Friday and the market close on Tuesday, the yield on a 30-year gilt rose 121 basis points to 3.77% at 4.98%.

What made this decision so destabilizing for financial stability was the structure of the UK liability-driven investment repo (LDI) market. It is a heavy user of long-term interest rate derivatives or gilt repos to gain leveraged exposure to long-term interest rates, as it aims to match the duration of its assets and of its liabilities. Under normal market conditions, managing the collateral for these positions is simple. However, the recent spike in interest rates caused such large declines in these positions that there was an immediate need for collateral.

For LDI funds with insufficient liquidity, this meant rapid liquidation of assets such as gilts and corporate bonds. At the same time, many larger pension plans that run their own programs were looking to meet margin calls for the same reason. So the LDI community ended up making similar adjustments at the same time with the same set of counterparts. This has become self-reinforcing, with higher yields causing further liquidation of fixed income assets, leading to even higher returns.

To break this loop, the BoE thought it had to intervene. The very announcement of the program and two small auctions on Wednesday and Thursday sent 30-year gilt yields down 113 basis points, already putting LDI funds in a better position.

Looking ahead, the BoE has given the LDI community and banks two weeks to clean up their positions. Whether that will be enough remains to be seen. Moreover, even though the stocks were not directly recommended by the Monetary Policy Committee, there is still a distinct risk that market participants will see this as quasi-fiscal dominance and start to wonder if the BoE can start to undertake QT given the fragilities of the gilt. market.


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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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