Bank of England intervention prevented a destructive ‘spiral’ after the mini-budget

The Bank of England said its intervention last month in the gilt market had prevented a “self-sustaining spiral” following Kwasi Kwarteng’s mini-budget, which could have wiped out the value of many funds held by pension companies.

In a letter to the House of Commons Treasury Committee setting out the thinking behind the September 28 dramatic decision, the Bank’s Deputy Governor for Financial Stability, Sir Jon Cunliffe, said the spike in gilt prices would have may have triggered “widespread financial instability”.

If the Bank had not intervened, a “large number” of liability-driven investment (LDI) funds would have ended up with a “negative net asset value”, reducing their value to providers to “zero” pensioners with significant holdings.

This would have triggered an “excessive and sudden” spike in interest rates on borrowing in the wider economy, Sir Jon said.

The Bank’s account – including charts showing gilt yields soaring after Mr Kwarteng’s statement – blows a huge hole in the government’s attempts to paint the market chaos as part of a global phenomenon caused by Vladimir Putin’s invasion of Ukraine.

It emerged as Mr Kwarteng was holding emergency talks with Britain’s biggest lenders over protecting homeowners amid soaring interest rates on mortgages, now at around 6% after more than a decade below 2%.

Senior executives from major banks and building societies have pressed the chancellor to extend a mortgage guarantee scheme that protects them against losses when lending to first-time buyers, but is due to end in December.

Labor Treasury spokesman Pat McFadden said the Bank of England’s letter ‘shows once and for all that the Tories’ kamikaze budget is to blame for the economic chaos we’ve seen, leaving people with rates skyrocketing mortgages”.

“This is a Tory crisis made in Downing Street,” Mr McFadden said. “The government’s reckless mistakes show that it cannot be trusted to manage public finances. They need to review this budget as soon as possible and urgently publish the OBR forecast tomorrow when they receive it.

On the morning of September 28 – five days after markets were spooked by Mr Kwarteng’s £45billion package of unfunded tax cuts – the Bank announced it was ready to inject unlimited sums in gilts to stabilize prices, with a maximum of £5 billion per day. be sufficient.

The action is due to continue until October 14, bringing the Bank’s intended maximum intervention to £65 billion. But Sir Jon said that up to Wednesday this week it had proved necessary to deploy just £3.7billion of his potential firepower, as the announcement itself had the effect of calming the steps.

Explaining the extent of the market chaos that prompted the unprecedented intervention, Sir Jon told the committee that on the Monday following Mr Kwarteng’s statement on Friday, 30-year gilt yields – essentially the interest the government owes pay on its loans – had increased by more than 0.8 percentage points.

Gilts are a preferred financial instrument for pension funds due to their long-term reliability, and market volatility is highly unusual.

Cumulative change in long-term government bond yields show sharp rise after mini-budget

(Bank of England)

“Throughout the day and well into the evening, the Bank received increasingly harsh market information from a range of market participants, and in particular LDI fund managers, signaling that conditions in the main markets, if they continued to deteriorate, would force them to sell large amounts of long-term gilts in an increasingly illiquid market,” Sir Jon said.

“Taken at face value, this market insight would have implied additional long-term sales of at least £50 billion in a short period of time, compared to recent average market trading volumes of just £12. billions of pounds a day in these mature sectors.”

After a brief rally early on Tuesday, yields rose another 0.67 percentage points later in the day “materially worsening the situation”, he said.

“The Bank has been advised by a number of LDI fund managers that, at prevailing yields, several LDI funds are likely to fall into negative net asset value.

“As a result, it was likely that these funds would have to begin the liquidation process the next morning.

“In this event, a large quantity of gilts, held as collateral by the banks that had lent to these LDI funds, was likely to be sold on the market, leading to a potentially self-perpetuating spiral and threatening serious disruptions in the markets of core funding and hence widespread financial instability.

Bank officials worked through the night of September 27, in coordination with the Treasury, to develop a plan to prevent the spiral from developing.

He told the all-party panel of MPs: “Had the Bank not intervened on Wednesday 28 September, many of the LDI pooled funds would have ended up with negative net asset values ​​and faced shortcomings in the collateral provided to bank counterparties.

“Defined Benefit (DB) pension fund investments in these LDI pooled funds would have zero value.

“If the LDI funds defaulted, the large amount of gilts held as collateral by the banks that had lent to these funds would then potentially be sold in the market.

“This would amplify stress on the financial system and further hurt the gilt market, which in turn would have forced other institutions to sell assets to increase liquidity and add to self-perpetuating falls in asset prices.

“This would have led to an even more serious disruption of the functioning of the central gilt market, which in turn could have led to an excessive and sudden tightening of financing conditions for the real economy.”

Outlining the scale of the crisis in the days following the mini budget, Sir Jon pointed out that the previous record daily rise in interest rates had been 0.29 percentage points during the so-called ‘run in cash” in 2020.

Measured over a four-day period, the rise in 30-year gilt yields was more than twice as large as the largest move since 2000 and more than three times as large as any historical move.

The 1.6 percentage point rise in the nominal 30-year gilt yield – from just 1.2% at the start of the year – in a matter of days was bigger than expected, even in fiscal years. management of the most catastrophic risks. .

The functioning of the gilt market was “severely strained”, with “particular pressure” on LDI funds, he said.

Sir Jon said that after the end of the buying program on October 14, the operation will “run smoothly and orderly once the risks to the functioning of the market are judged by the Bank to have diminished”.

He added: “The approach to unwinding will depend on, among other things, the magnitude of the actual purchases, the market conditions during those purchases and the market conditions at the end of the purchases.”

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