'Financial Stability Risk' - Brits see quick return of easy money

The Bank of England (BoE) is intervening in bond markets as part of a contingency plan to contain the crisis in the domestic government bond market. The monetary authorities warned of a "significant risk to the financial stability of Great Britain" in view of a fundamental revaluation on the financial market. Among other things, there is a risk of an “unjustified tightening of financing conditions and reduced access to credit for the real economy”.

To counteract this, central bankers announced on Wednesday that they would be buying long-dated government bonds. The program begins immediately and will run through October 14th. Purchases are made to whatever extent is necessary to achieve the stabilization goal. A program of bond sales should actually start next week as part of the so-called quantitative tightening.

The turbulence in the British bond market began last Friday with an announcement by the new government. In addition to extensive relief for households and companies through a guaranteed upper limit on energy costs, Finance Minister Kwasi Kwarteng has announced significant tax breaks.

He expects this to give him a growth spurt. The measure was not well received by the markets, especially since the package is to be financed exclusively from government debt and no analysis of the impact was presented. An additional bond issue worth £70 billion is planned for the current year alone. In addition, inflation would be fueled further.

"The Bank of England is stepping down from the sidelines with direct bond market intervention," commented Mohamed El-Erian, President of Queens' College Cambridge and advisor to Allianz. The announced step makes it clear what dilemma the central bank is facing. Actually, it has interest rate hikes and a winding-up of previous bond purchases on the program to get inflation under control. Instead, she feels compelled to act with an easing instrument.

Yields on long-dated government bonds, known as gilts, have been rising for days as part of the turmoil. Bonds with ten-year maturities rose by around 1.5 percentage points in September and were now at 4.5 percent. They hadn't recorded such a significant leap in 50 years. Longer-dated gilts are now outperforming their equivalents in Italy and Greece, meaning the UK government is more expensive to finance than southern Europeans.

The BoE's measure quickly had an effect. 30-year Treasury yields fell from 5.1 percent to 4.3 percent within minutes of the announcement. This relaxation is important for pension funds and insurance companies, among others, which traditionally invest a large part of their assets in the bond market. According to reports in the British media, several providers have come under pressure. Because of the turmoil, they were forced to liquidate investments in order to make up the margin calls, their interest rate hedging strategy.

The day before, the International Monetary Fund (IMF) had criticized the British government's growth strategy. The multilateral organization said she was monitoring the situation closely and was in contact with the responsible authorities. "Given the high inflationary pressures in many countries, including the UK, we advise against large untargeted fiscal packages at this time," said the fund, which is considered lender of last resort. It is important that fiscal policy does not conflict with monetary policy. The IMF also criticized the fact that it was mainly the wealthy who would benefit from the tax cuts and that the step would likely further exacerbate inequality in the country.

US Treasury Secretary Janet Yellen also stressed that she was keeping a close eye on developments. It still looks like the problems are limited to Great Britain. The rating agency Moody's sees the danger that Kwarteng's measures will achieve the opposite of their goal. The significant fiscal stimulus, which is financed by debt, would inevitably lead to a tightening of monetary policy, which would depress the growth forecast in the medium term. The country's rating does not affect the agency's warning.

A significant problem in the country is that the volume of bonds the government intends to use to fund its measures "is far too much for demand," said Ray Dalio, founder of wealth manager Bridgewater Associates. As a result, investors would say goodbye to bonds and currency. “The UK government is acting like an emerging market government that is producing too much debt in a currency for which there is not much global demand.”

Whether the central bank's intervention will be enough to restore financial actors' confidence in the British government is questionable, says Susannah Streeter, an analyst at Hargreaves Lansdown. "The move the bank has taken, two days after it announced it would wait until November, smacks of panic." There is also frustration that the government is sticking to its position and unwilling to reverse course . "Instead, the Bank of England was forced into a policy U-turn."

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