Andrew Bailey will come under scrutiny in Washington this week as the Bank of England prepares to end its emergency support for government bonds on Friday.
Appearing for the first time since the BoE had to intervene in the gilt market over fears of an all-out financial crisis following the UK government’s ‘mini’ budget last month, the central bank governor will need to reassure investors on the market malfunction is over and the bank has inflation under control.
Long-term government borrowing costs have climbed over the past week, although they remain below the 20-year high that prompted the central bank to enter the markets. Yields on 30-year gilts ended the week at 4.39%, down from a low of 3.64% following the BoE’s intervention last month.
Bailey is in the US capital for the IMF and World Bank annual meetings and participates in several side events. But his trip abroad will not protect him from many problems filling his baccalaureate at home. These have multiplied since Chancellor Kwasi Kwarteng’s September 23 tax event and his unfunded tax cuts have undermined confidence in Britain’s economic policy around the world.
Allan Monks, UK economist at JPMorgan, said the BoE was now “caught in the crossfire” between meeting financial market expectations of raising interest rates from the current 2.25% to 5.75% the next day. next year and fears that much higher mortgage rates will push the UK into an unnecessarily deep recession.
However, there are tensions within the BoE over whether it is now targeting lower gilt yields, leading to lower government borrowing costs.
Since the central bank announced its £65billion bond-buying program to end the crisis in the liability-driven investment element of occupational pensions, it has tried to make the case to the times that lower yields are a sign of success for financial stability and lowering them is nothing to do with monetary policy.
Sir Jon Cunliffe, deputy governor of the bank, said the main sign of a well-received intervention was that it “led to a [1 percentage point] drop in the 30-year gilt yield that day,” but BoE officials insist it was not a monetary policy action, even though it used the policy tool monetary bank – quantitative easing.
This confusion over the purpose of the intervention underscored the potential difficulties the bank will face on Oct. 14, when it announced it would stop intervening and buying bonds. The deadline helps the BoE demonstrate that it was not looking to restart normal QE operations, but leaves traders wondering if the bank will step in again if there is further disorder in the market.
Jon Jonsson, a senior bond portfolio manager at Neuberger Berman, said he “didn’t understand why they put dates on this thing. . . everyone is waiting now and you will see the market start testing the BoE again”.
James Athey, senior fund manager at Abrn, agreed, predicting the market was likely to “test” the bank ahead of the October 14 deadline, and warned it could be forced to extend its buying.
There are signs that this is already starting to happen. The rise in yields over the past week came as the BoE decided to buy far fewer bonds than its program allows. In the first eight days of its 13-day intervention, the central bank bought less than £4 billion out of a potential 40 billion gilt.
These potential difficulties reveal a second tension facing the central bank: it must choose between meeting market expectations on interest rates or risking a further fall in sterling.
Financial markets are keen to see the scale of the “meaningful monetary response” promised by BoE Chief Economist Huw Pill at the next Monetary Policy Committee meeting and want it to be large enough to support interest in buying UK assets.
But Mark Dowding, chief investment officer at BlueBay Asset Management, said there were no easy decisions for the BoE.
“Essentially you have the choice to control the pound and you end up with ultra-high rates, a housing market crash and a crisis of confidence in government,” he said. “Otherwise there is a tacit acceptance to keep rates lower and to accept that inflation can be a little higher for a little longer and then the pound will fall further towards parity with the euro and the dollar. I think this last result will be seen as the lesser of two evils.
Jonsson said: “How do you make UK assets attractive enough to stabilize the currency – you have to let real yields rise.”
The third problem for Bailey is that he will also face tough questions not only about the £65bn central bank intervention, but also about the regulation of LDI managers and funds by the Financial Conduct Authority and the Pensions Regulator. Bailey served as FCA’s chief executive between 2016 and 2020.
Bailey can be glad that Kwarteng, who is heading to Washington later in the week, is under even more pressure than he is after his unfunded tax cuts, U-turns on the rate of 45p income tax and the need to demonstrate that the government takes the sustainability of public finances seriously.
The central bank governor can also take comfort that UK financial markets have been much less volatile over the past week, which some market participants attribute to the BoE.
“Ultimately, the BoE made it clear to the market that it was ready to step in to protect a dysfunctional market,” said Iain Stealey, head of international fixed income at JPMorgan Asset Management.
But these are small comforts for Bailey who, having been forced to relaunch QE against the wishes of the BoE, now faces the specter of having to forcefully raise interest rates, putting the economy at greater risk, or to see the financial markets dump the pound again. Every word he says in Washington will be scrutinized.