UK bond crisis Apex bank dragged into Truss’ fiscal mess

The British pound rose on Thursday in volatile trade as investors awaited the impending deadline for the Bank of England (BoE) to end an emergency bond-buying program. A day earlier, the British currency fell to an almost two-week low but rebounded after the Financial Times reported that the BoE had signalled privately to lenders that it was prepared to extend its bond purchases beyond Friday’s deadline, if market conditions demanded it. Additional support for UK sovereign debt and sterling came following the news that Prime Minister Liz Truss is due to announce that she backing down from the package of tax cuts her government announced in late September.

The Bank of England decided earlier this week to expand its emergency purchases of UK government bonds — known as gilts — aimed at calming financial markets riled by the government plan to cut taxes without a clear plan of how they will be financed. The BoE doubled to £10 billion ($11 billion) the amount of bonds it is prepared to buy daily on the open market to stem rising borrowing costs. Speaking in Washington this week, BoE Governor Andrew Bailey said it was up to the funds concerned to rebalance their holdings. “My message to the funds involved: you’ve got three days left now. You have got to get this done,” he said. Bailey’s statement was an attempt to draw a line in a rapidly haemorrhaging market, to make a show of strength. But the outcome is far from certain, as the government and the central bank seem to be pulling in opposite directions. As one trader put it, the situation is like a car being driven by two people — one with her foot on the accelerator, the other with his foot on the brake.

The BoE stepped in two weeks ago with a £65 billion bond-buying program to calm the market after Kwasi Kwarteng, who was dismissed from his post as Treasury chief on Friday, unveiled plans on September 23 for £45 billion worth of tax cuts and £60 billion in increased spending to help households and businesses survive increases in energy prices this winter. Truss said in parliament on Wednesday that the government would not reduce spending, leaving many asking how it plans to finance its tax cuts. She said economic growth would cover the gap. However, the UK economy shrank 0.3% in August month-on-month and economists told the government that growth is unlikely in the foreseeable future. The government’s credibility is already on a rocky path. Charlie Bean, a former deputy governor at the central bank, told BBC Radio 4’s Today program on Thursday, for example, that the turbulence felt by the markets was the result of “unfunded tax cuts and the looming prospect” of more in the medium term.”

The BoE’s bond purchases worked initially, but the bank said on Monday that volatility on bond markets again posed a “material risk” to the UK’s fiscal stability after government bond yields, which move inversely to prices, rose to levels last seen after the government announced plans for tax cuts late last month. The sell-off hit index-linked bonds especially hard, with the yield on 30-year bonds rising over 5% — a level that had previously sounded the alarm bells because it means unsustainable borrowing costs for Britain. Meanwhile, UK pension schemes are racing to raise hundreds of billions of pounds to shore up derivatives positions before the BoE’s Friday deadline. Bond yields rose so far and so fast that the funds’ risk insurance products were demanding huge amounts of cash, reportedly about £320 billion, forcing pension funds into a fire sale of bonds, which drove prices still lower and yields higher.