The U.K. Only Has A Few Ways To Calm Markets Before BOE Pulls Back

(Bloomberg) -- The guardians of the U.K. economy have few good options available as Friday’s deadline for the Bank of England to end its emergency gilt purchases looms with markets still skittish. 

Governor Andrew Bailey is adamant that the £65 billion ($72 billion) emergency backstop facility will close as planned at the end of this week. 

That’s even as some warn that exiting will spark another bout of turmoil in markets that followed the government’s unfunded fiscal plan on Sept. 23, and threatened a full blown financial meltdown.

But neither the central bank nor the government have an easy path to calmer markets with most choices carrying risks, including to their own credibility. 

Asset managers, regulators and bankers around the divided over how the next few days will unfold. 

Here’s a rundown at some of the options.

Bailey Folds

Thilo Schweizer, head of European affairs at Commerzbank, said people were skeptical that Bailey would be able to hold his position. 

“The market may test him, and if they do he will eat his own words,” Schweizer said.

If the BOE does backtrack on Bailey’s pledge to end gilt purchases, that would harm his standing at a time when the government’s own loss of credibility is central to the market mayhem.

Kwarteng Faces the Market

Others said the BOE should pull back because not doing so would fuel the view it’s always willing to bail out markets and also jeopardize its independence from politics by plastering over problems created by the government. It would also lead some to question Bailey’s comments in the future. 

Katherine Garrett-Cox, chief executive of the U.K. subsidiary of the Gulf International Bank of Bahrain, said: “There is not a silver bullet on this. The Bank has got to keep within the guardrails -- its framework and long-term policy mechanism.”

That scenario would force Chancellor of the Exchequer Kwasi Kwarteng to act. 

Senior Tories are also urging the chancellor to rip up his mini-budget to avoid a financial crisis.

“The best sequence from the markets point of view is that by Monday morning, you’ve got further chunks of the fiscal plan which are out there,” said Gilles Moec, chief economist at AXA Investment Managers. “That means when we wake up on Monday morning the market can reassess where it thinks fiscal policy is going and then the Bank of England is not forced into additional action.”

Moec says that a reversal of corporate tax cuts could be “part of the discussion”, while the markets would also be bolstered if there was promise of extensive spending cuts. 

“It makes sense for the BOE to want to be finished with asset purchases when the attention shifts to the government and clarification of their new fiscal plans,” said Kristin Forbes, a professor at Massachusetts Institute of Technology and former member of the BOE’s monetary policy committee. “Then the onus shifts to the government to defend its fiscal plan and the BOE can take a back seat.”

Delay QT

The BOE may also choose to delay the start of so-called active quantitative tightening, or selling gilts back to the market which they accumulated under previous bond-buying programs. 

The central bank has already postponed the start of their 80-billion-a-year program till the end of October -- but some investors see that date being pushed back again.

Market Chaos Throws Doubt on BOE Plan to Flip to Bond Sales 

“This is a risky time to see the BOE shift to active sales,” said Forbes, despite volumes being relatively small. “The fact that they are doing it, especially during such volatile times, could take on more significance than it should.”

A Creative Solution

Steven Major, head of fixed income research at HSBC, said another option to ease congestion in the markets would be for the Debt Management Office, which is part of Kwarteng’s Treasury, to change its funding plans. 

If the DMO opted to raise very short-dated money -- a part of the gilt market that is not seeing demand problems -- that might help ease the strains in longer-term debt sufficiently to avoid another rout. 

Everyone Gets Lucky

And maybe the rout just might not materialize. Funds still have two days of emergency liquidity support to help them clean up their portfolios and after that will keep in place a liquidity facility that will allow banks to borrow cash from on a temporary basis against collateral such as some corporate bonds on behalf of their LDI clients. That runs until Nov. 10. 

“If you’ve put in place the mechanism to deal with the liquidity problem and you said you were going to stop intervening, for sure the bar needs to be high,” said AXA’s Moec. “For technical reasons and for the sort of political economy reason which is that otherwise your credibility is on the line.”

The BOE needs to “make it clear that investors won’t get bailed out,” said Forbes. “If you’re going to take leveraged bets and you’re on the wrong side, you will suffer losses. The BOE just wants to make sure any losses are not systemic.”

All the same, one senior financier warned that relying on that outcome was a risky proposition. They pointed out that those programs require funds to go through the commercial banks and those lenders could be uncomfortable taking risk onto their balance sheets even temporarily.

More stories like this are available on bloomberg.com

©2022 Bloomberg L.P.