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OPINION

The bond vigilantes are back with a vengeance

In public at least, the Bank of England has been determined to end its gilts intervention when it said it would, but it’s getting harder for the BoE to manage its conflicts – and the market doesn’t know what to believe any more.

Mark Baker on capital markets 1920px

Jim Leaviss, at M&G Investments, could not have picked a better time for the relaunch of his Bond Vigilantes blog. With markets renewing their battering of sterling and of UK long-dated gilts amid investor fright at the policies of new prime minister Liz Truss and her chancellor of the exchequer Kwasi Kwarteng, there has rarely been a clearer example of exactly what academic Ed Yardeni had in mind back in July 1983.

“If the fiscal and monetary authorities won’t regulate the economy, the bond investors will,” wrote Yardeni in his weekly market commentary then. Giving it the title of Bond Investors Are the Economy’s Bond Vigilantes, he invented the now familiar phrase.

Leaviss, like Yardeni, in a recent Financial Times oped on the topic, likes to reference the most obvious period of bond vigilantism – the 1990s administration of US president Bill Clinton, when 10-year US Treasuries topped 8%.

Clinton’s strategic adviser James Carville was blessed with great skill in turning a phrase. On the concept of reincarnation, he said he had originally wanted to come back as the president, the Pope or a .400 hitter. “But now I would prefer to come back as the bond market, [as] you can intimidate everybody.”

Truss and Kwarteng are certainly getting a sense of that now. They might do well to ponder another of Carville’s gems: “It’s the economy, stupid.”

Precarious position

This week, the biggest fallout from the chaos in the UK seems to have been at the Bank of England (BoE) – a remarkable turn of events given that (a) the government’s much-unloved fiscal plan is not the BoE’s fault and (b) the BoE initially appeared to have settled some nerves with the “whatever-it-takes” intervention in gilts that it announced in late September.

One underlying problem is that the BoE is stuck in the same uncomfortable place in which many of its independent central-bank peers around the world find themselves – balanced precariously on the sliver of territory that links their inflation management mandates on one side and their governments’ fiscal policies on the other. In the UK, those two sides are lurching away from each other, leaving the BoE struggling to avoid falling into the gaping chasm called financial instability.

Another problem is that the “whatever-it-takes” nature of the BoE’s intervention in gilts has turned out to be somewhat more limited than some in the market would have liked.

But even that might have been manageable – if only the BoE had not, once again, screwed up its communication and ruined all its good work. That is the third problem.

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Bank of England governor Andrew Bailey. Photo: Reuters

At almost every opportunity when talking about the BoE’s emergency bond-buying backstop scheme to settle the worst of the market dysfunction as liability-driven investing (LDI) pension schemes rushed to raise cash to settle margin calls as long gilt yields soared, governor Andrew Bailey has maintained that the intervention does not constitute a return to quantitative easing (QE).

And contrary to the cries of derision at the time the plan was announced, so it has proved. After all, the BoE has deployed only a fraction of the firepower that it said it would make available precisely because it is (correctly) operating its scheme in the way it said it would – as a backstop bid, not as a buyer of first resort. It is (equally correctly) not seeking to fundamentally reprice the market, but to provide a bid if there is no other.

Tuesday and Wednesday brought fresh confusion, with Bailey first telling the annual meeting of the Institute of International Finance (IIF) in Washington that pension funds had three days left to get their house in order, followed by media reports of off-the-record briefings that the BoE might consider extending the backstop scheme, only to be dashed when the BoE restated on Wednesday that the scheme would end on Friday. Cue yet another whipsawing of gilts.

It doesn’t help that Bailey and the BoE were already firmly on the back foot, widely pilloried for moving too late on inflation and moving too slow when they finally acted – witness the widespread disappointment at the mere 50 basis point rise at the most recent meeting of the BoE’s Monetary Policy Committee (MPC), and the resulting expectation of a much more brutal rise in its November get-together.

If the government finds itself compelled to step in with some kind of structural support for pensions, that is going to land squarely back on the BoE’s doorstep before too long in the form of even more pressure to raise rates

Now there is renewed criticism of the BoE’s messaging to markets – how can it appear to be feeding information that support might continue while its governor publicly states the opposite?

It should be noted that there is much more than just the gilt intervention going on. There are multiple support schemes that the BoE has introduced, including new repo facilities aimed at relieving much the same pressures on LDI pensions. It is only the gilt purchases that are due to end on Friday.

It is also worth asking – considering where we were rather than where we might have wished to have been – what alternatives were available to the BoE.

Should Bailey have committed the BoE to buy gilts at whatever price investors were offering, a policy that would obviously constitute a complete pivot back to QE in a way that the backstop bid does not?

Should the commitment have been open-ended, to be wound up only when markets had stabilized, a policy that would have proved ever-more difficult to unwind in anything other than a new taper tantrum, and would have invited accusations of manipulating gilt yields on behalf of the government?

Some commentators now demand to know what the BoE will do if market conditions still require it to act beyond Friday. It would be bizarre for those calling for the BoE to extend the scheme to complain if it decided to do just that. Equally, it should not been seen as perplexing or inconsistent to want to push markets and pension funds as hard as possible to meet the first deadline, but then also extend that deadline if that is what makes most sense at that moment.

Fine line

There is no doubt that this week’s messaging confusion has been an avoidable embarrassment, but the BoE is treading an extremely fine line between the conflicting aspects of its mandate. It does not help that Bailey’s often insouciant demeanour and delivery are aggravating to many.

But the danger that the BoE now faces is mission creep in its financial-stability role. It has rightly demonstrated that it is not in the business of using policy to lower the UK government’s borrowing costs. The next challenge is to show that it is not about to engage in an open-ended bailout of a portion of the country’s defined benefit pension schemes.

However, the BoE is unlikely to escape that for long. If the government finds itself compelled to step in with some kind of structural support for pensions, that is going to land squarely back on the BoE’s doorstep before too long in the form of even more pressure to raise rates.

Back at the Bond Vigilantes blog, things are looking up. Sterling credit – and even long gilts – deserve a look right now, argued Matthew Russell in a post on Wednesday. In the past 10 years, sterling investment-grade credit spreads versus gilts have only been wider during Covid, and all-in yields are nearing 7%.

He is not the only one to be getting worked up. Karen Ward, JPMorgan Asset Management’s chief market strategist for EMEA, wrote on Wednesday that she was getting excited about bonds for the first time in a decade. She notes that global government bond benchmark yields are 3% now compared with 1% at the start of the year. Investment grade has jumped from 2% to 5% and high yield is almost at 10%.

And what of gilts? The convexity of the long end has sent prices tumbling, notes Russell, with 40-year paper that was at 96 at the end of 2021 now in the 20s. This is not investment advice, obviously, but if you think yields might fall even just a little from where we are now, you might be tempted to fill your boots.