For the third time in a fortnight the Bank of England has deployed billions of pounds to buy government bonds and calm financial markets. The mini-budget on 23 September led to panic selling by pension funds, causing them to dump government bonds to raise money. The rout spooked foreign investors, and the Bank is now struggling to bring order back to the markets, despite spending £3.3bn on Tuesday in its single biggest daily intervention since the turmoil began.
What is the Bank worried about?
Threadneedle Street wants to stabilise the trading by cash-strapped pension funds in UK government bonds, known as gilts. It also wants to prevent a fall in the value of gilts becoming permanent, increasing the cost of government borrowing.
Since the government’s mini-budget, the threat of much higher borrowing costs has become apparent and the only way to prevent a Greece-style run was for the central bank to intervene.
The latest session of panic selling has centred on index linked gilts, which are being sold by pension funds to shore up their precarious finances.
What has the Bank of England done?
Central banks want financial markets to have a network of buyers and sellers always willing to trade. It is what keeps markets “liquid”, even when prices are falling. But steep falls in the price of financial assets can cause panic and mean there are only sellers.
If we think about gilts as mortgages, then the government has issued millions of mortgages with different repayments dates ranging from a few hours to 30 years.
Final salary pension funds are among the largest buyers of these mortgages, making them one of the largest lenders to the UK government.
When Kwarteng announced huge tax cuts in September without saying how they would be funded, bond traders predicted a surge in government borrowing. This led to a rout in gilts, which in turn hit pension funds. They were forced to raise cash quickly to cover margin calls on hedging arrangements. The way pension funds chose to raise cash was by selling gilts, which drove the value of these gilts even lower.
With no buyers, the Bank stepped in on 28 September to act as buyer of last resort, promising to spend up to £5bn a day in bond markets until this Friday 14 October.
Bonds recovered, but by Monday of this week their value was falling sharply again, prompting the Bank to increase its daily limit to £10bn. With investors concerned about Friday’s “cliff-edge”, when the Bank has said its support will end, the turmoil continued. On Tuesday, the Bank extended its purchasing to cover index-linked government bonds.
What is the difference between index-linked bonds and other bonds?
In the 1980s, after the UK had suffered from double-digit inflation for much of the previous decade, the government began selling a new type of bond that protected investors from rising prices.
The pitch to potential investors went: what country would sell inflation-linked bonds if it was going to let prices rip?
The gilts were linked to the retail prices index. In recent years the government has increased the proportion of bonds that are index-linked to stress how committed it is to low inflation.
What is the Bank hoping to achieve?
A sense of calm that shows the UK can oversee an orderly market in government bonds that international investors can safely profit from.
Britain relies heavily on its reputation for deep and sophisticated financial markets to be Europe’s main financial centre. Despite quitting the EU’s single market and customs union it remains one of the world’s three financial largest centres, linking New York and Tokyo.
Why has the Bank put a limit on the intervention?
The Bank of England cannot let itself become a permanent backstop for the City that steps in whenever there is a bit of turmoil. It creates a moral hazard that encorages risky behaviour.
A time limit for its bond buying until the end of this week was to allow pension funds to untangle their complex derivative positions, dust themselves down and get back to providing workers with their annual retirement incomes.
Will the Bank extend its intervention anyway?
Pension funds have called for an extension to prevent a repeat of this week’s renewed selling spree. The bank will want to resist, but unless it can claim the pension problem is resolved, an extension seems inevitable.
Some analysts also expect further turmoil in financial markets linked to growing fears of a global recession and the fallout from an increasingly bitter and bloody war in Ukraine. The Truss government’s unfunded spending plans leaves the UK especially vulnerable in this situation and less likely to be seen as a haven when panic strikes.
What does it mean for my pension scheme?
There are defined benefit pension schemes managed by insurance companies and there are defined benefit pension schemes that are independently managed and attached to an employer. This second group is overseen by the Pensions Regulator.
The difference is important because insurance companies have an extra layer of regulation. They are also monitored by the Bank of England offshoot, the Prudential Regulation Authority, which is the overarching financial watchdog.
Insurance companies, like banks, have been forced since the 2008 financial crash to keep aside reserves for difficult circumstances. Independent pension schemes have relied on their sponsoring employers for back up funds.
Is my pension safe?
Once pension schemes have succeeded in solving their liquidity issues, the bonds they hold will pay a higher rate of interest and over the longer term.
However, if more pensions schemes than previously thought have bought complex derivatives only to find they have turned toxic, we could be in for a bumpier ride.
How many pensions are affected?
A total of more than 18 million people are affected by the pension crisis in some way. Of these, a little more than 2.7 million people still pay into defined benefit schemes. About 4.77 million people belong to schemes closed to new members. A further 3.4 million are in schemes that have shut to new accruals or are winding up. The regulator says a further 5 million have left the employer and are deferred members while 4.3 million are pensioners paid by a defined benefit scheme.
