Andrew Bailey will face intense scrutiny in Washington this week as the Bank of England prepares to end its emergency support for government bonds on Friday.
Emerging for the first time since the BoE had to intervene in the gilt market over fears of an all-out financial crisis in the wake of the UK government’s “mini” budget last month, the central bank governor will need to reassure investors that both market dysfunction is over and that the bank controls inflation.
Long-term government borrowing costs rose over the past week, although they remain below the 20-year high that prompted the central bank to enter the markets. 30-year gilt yields ended the week at 4.39%, up from a low of 3.64% following the BoE 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 won’t protect him from numerous problems filling his inbox at home. These have multiplied since Chancellor Kwasi Kwarteng’s tax event on 23 September and his unfunded tax cuts have undermined confidence in UK economic policy around the world.
Allan Monks, UK economist at JPMorgan, said the BoE was now “caught in the crossfire” between meeting financial markets’ expectations that interest rates would rise from the current 2.25% to 5.75% next year and concerns that much higher mortgage rates would push the UK into an unnecessarily deep recession.
However, there is tension within the BoE over whether it is now targeting lower gilt yields, bringing with it lower government borrowing costs.
Ever since the central bank announced its £65bn bond-buying program to end a crisis in the liability-based investment element of occupational pensions, it has tried to argue that lower yields are a sign of success for financial stability and that reducing them is Nothing to do with monetary policy.
Sir Jon Cunliffe, the bank’s deputy governor, said the main sign of a welcome intervention was that it “led to a [1 percentage point] drop in 30-year gilt yield that day,” but BoE officials insist it was not a monetary policy action, even though it used the bank’s monetary policy tool: quantitative easing.
This confusion over the purpose of the intervention has underscored the potential difficulties the bank will face on October 14, when it has said it will stop intervening and buying bonds. The deadline helps the BoE show that it was not looking to restart normal QE operations, but leaves traders wondering if the bank will step in again if new market disarray breaks out.
Jon Jonsson, senior bond portfolio manager at Neuberger Berman, said he didn’t “understand why they put dates on this. . . everyone is waiting now and you will see the market start to test the BoE again.”
James Athey, senior fund manager at Abrdn, agreed, predicting the market was likely to “test” the bank before the Oct. 14 deadline, warning it could be forced to extend purchases.
There are signs that this is already starting to happen. The surge in yields over the past week came as the BoE decided to buy much less bonds than its schedule allows. During the first eight days of its 13-day intervention, the central bank bought less than £4bn of a potential £40bn.
These potential difficulties reveal a second tension facing the central bank: it must choose to meet market expectations on interest rates or risk a further fall in sterling.
Financial markets are very keen to see the size 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 the 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 option 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 accept that inflation may be a bit higher for a bit longer, and then the pound will fall further towards parity with the euro and the dollar. I think this latest 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 difficult 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 was CEO of the FCA between 2016 and 2020.
Bailey may take some cheer from the fact that Kwarteng, who heads to Washington later in the week, is even more pressured than he is after his unfunded tax cuts, U-turns in the US income tax rate 45 pence and the need to show that the government is serious about the sustainability of public finances.
The central bank governor can also rest assured that UK financial markets were much less volatile last week, for which some market participants credit the BoE.
“Ultimately, the BoE made the market understand that it is willing to step in to protect a dysfunctional market,” said Iain Stealey, head of international fixed income at JPMorgan Asset Management.
But these are small consolations for Bailey who, after being forced to restart QE against the BoE’s will, now faces the specter of having to forcibly raise interest rates, putting the economy at greater risk, or seeing how financial markets dump sterling again. Every word he speaks in Washington will be closely scrutinized.