‘Time-limited’ and ‘whatever it takes’ don’t sit comfortably together. Even if a law of diminishing returns suggests the legendary ‘whatever it takes’ warning from policymakers to markets is waning somewhat, the phrase still derives power from its simplicity and open-ended commitment to overwhelming force.
Used most effectively in the financial context by then European Central Bank chief Mario Draghi 10 years ago, it all but ended the raging euro zone sovereign debt crisis of the day simply by signalling unlimited ECB use of all available firepower for however long it took to steady the ship. No taboos, with no size or time constraints.
Circumstances, context and exact phrasing may be different this week, but the Bank of England did ape some of that language on Wednesday in its dramatic decision to buy British government bonds to prevent an implosion of the so-called gilt market.
As market dysfunction risked a doom loop of pension fund cash calls and forced selling due to soaring yields, wildly exaggerated by the UK government’s tax-slashing fiscal plan last Friday, the Bank clearly had to act - even though ostensibly against the thrust of its ongoing tightening of monetary policy.
“The purpose of these purchases will be to restore orderly market conditions,” the BoE statement read. “The purchases will be carried out on whatever scale is necessary to effect this outcome.”
Forceful words, with some echoes of 2012.
Like the ECB 10 years ago - or again this year when it designed an anti-fragmentation tool to limit intra-euro borrowing spreads - the BoE justified Wednesday’s intervention by the need for properly functioning markets to adequately transmit its monetary policy.
Yet unlike the ECB a decade previously, the BoE’s underlying monetary policy is the polar opposite of what it has to do to calm markets and risks side-swiping its interest rate rise campaign to control inflation. More particularly, it cuts across its commitment to run down its 800 billion plus balance sheet by actively selling 80 billion pounds of gilts over the coming year, part of its quantitative tightening pledge (QT).
So much so, the BoE was compelled to qualify the seemingly forceful “whatever scale is necessary” line with what Deputy Governor Dave Ramsden on Thursday stressed would be a “strictly time-limited” operation.
The hope is it just buys two weeks of time for pension funds to sort out cash and collateral crunches at the long end of the bond market - and allow the BoE to unwind those purchases ‘smoothly’ once again, resume the postponed QT sales next month and deliver what futures markets now assume will be a whopping 1.25 percentage point increase in its policy rate on November 3. That’s a hopeful expectation.
If the problem was just about quarter-end quirk in derivatives hedging, perhaps it works.
But if the central problem is soaring bond yields and swap spreads amid sky-high inflation expectations, rising rates, unfunded tax cuts and a plummeting pound - then it may just kick the issue into year-end at latest.
“While the Bank of England’s intervention on Wednesday averted a vicious cycle of forced sales that had begun, the underlying risks from high inflation, a weak pound and uncertainty over the government’s fiscal plans remain,” said Invesco Solutions Portfolio Manager Derek Steeden.
Steeden said collateral calls are expected when gilt yields rise and most pension schemes have a pre-agreed order of what assets to sell first. But while schemes had been working through these reserves in recent months as yields climbed, he said the latest spike, which saw 30-year interest rate swaps balloon by more than 100bp, means they now need to sell well beyond the gilt market, not least as pressure to ‘de-risk’ funds increases as discount rates determining funding levels are so much higher.
“This is not over yet – many UK pension funds invest globally but have sterling liabilities and use currency hedging programmes to help neutralize the impact of currency moves,” he stressed. “These programmes have yet to settle losses resulting from the falling pound.”
So if the BoE can’t then put the fire out completely over the next couple of weeks, the “time-limited” commitment may become fuzzier than two weeks - complicating its monetary policy further in a way chief economist Huw Pill on Thursday swore it would not.
It could even end up in a confusing scenario HSBC calls ‘operation twist’, where it ends up buying long-dated gilts and selling short-dated paper at the same time, and inverts the yield curve even more. Either way, sterling’s vulnerability will continue to draw speculators who now see myriad policy inconsistencies. Hedge funds are licking their lips.
John Floyd’s Floyd Capital Management reckons gilt intervention that lower yields makes it difficult to fund the UK massive external deficit and a weaker currency will just have be the equilibrating mechanism. Veteran trader and family office manager John Taylor was more blunt: “It’s never too late to be short sterling.”
Stanley Druckenmiller, who helped marshal 1992’s billion-pound bet on sterling’s exit from Europe’s exchange rate mechanism when he was at Soros Fund Management, doubts the BoE plan this week will improve the bigger picture.
“The situation in England is quite serious because 30% of mortgages are heading toward variable rates,” Druckenmiller said. “What you don’t do is go and take taxpayer money and buy bonds at 4%. This is creating long term problems down the road.”
Unfortunately, time is not on the BoE’s side.
The opinions expressed here are those of the author, a columnist for Reuters.—Reuters
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