U.K. Financial System Gets Gilt-Edged Relief

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By Fredrik Repton

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

Given the extraordinary intervention, it is worth taking stock of what caused the BoE to take such forceful actions. From the point that the chancellor announced the U.K.’s “mini-budget” last Friday to the market close on Tuesday, the yield on a 30-year gilt increased by a stunning 121 basis points, from 3.77% to 4.98%.

What made this move so destabilizing to financial stability is the structure of the U.K.’s liability-driven investment (LDI) pensions market. It is a heavy user of long-dated interest-rate derivatives or gilt repos to gain levered exposure to long-term interest rates, as it aims to match the duration of its assets and liabilities. In normal market conditions, the collateral management of such positions is straightforward. Nonetheless, 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 cash, this meant rapid liquidation of assets such as gilts and corporate bonds. At the same time, many larger pension schemes that run their own programs were looking to meet margin calls for the same reason. Thus, the LDI community ended up doing similar adjustments at the same time with the same set of counterparties. This became self-feeding, with higher yields leading to further liquidation of fixed income assets, leading to even higher yields.

To break this loop, the BoE believed it had to intervene. The very announcement of the program and two small auctions on Wednesday and Thursday caused 30-year gilt yields to fall 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 get positions in order. It remains to be seen whether this will be enough. Additionally, even though the actions were not recommended by the Monetary Policy Committee directly, there is still a distinct risk that market participant will view this as quasi-fiscal dominance and start questioning whether the BoE can commence QT at all given the fragilities in the gilt market.

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