Not the Bank of England and its failed bond purchases again!? The markets just can't get enough of this Gilt trip ....

Friday 12th August 2016

  

Not the Bank of England and its failed bond purchases again!?  The markets just can't get enough of this Gilt trip ....

ref:- "Fears for future determine tight grip on gilts", The Financial Times, Markets and Investing, Analysis: Capital Markets

Before anyone says it, we know that we've been dancing around this subject quite a lot this week. But in our defence, we are supposed to draw attention to what catches our eye in the financial media and just at the moment the whole issue of the BoE's failure to get hold of its intended amount of long bonds, its global effects and what exactly it means is not giving anything else much of a look-in.

The Bank's inability to attract enough offers of long-end gilts even though it was prepared to pay over the market price for them on Tuesday would be pretty big news in any circumstances. The fact that it sparked another leg down in GLOBAL bond yields (and leg up in prices) is also a vivid illustration of how the world's debt markets are moving in sync even if conditions may vary from one nation to the next. But what is about longer-dated bonds that made them so hard to get hold of when the BoE had no difficulty in finding plenty of offers of short and medium-dated paper? And what does it mean for the ongoing QE programme which after all is only one week into a six month process?

It's not as though there aren't any long-dated gilts out there  --  in fact, there are about £500bn worth of them in private hands. That few of the holders of such paper could be tempted to sell is all about  who those holders are, and thus we find ourselves back with pension funds (again!), and insurance companies.

As we've been discussing all week, longer-end government bonds have been perfect investments for pension funds as they offer decent and secure returns with which to meet pension funds' future responsibilities .... or at least they have done in the past. To use the FT's example:  a 2042 gilt could have been bought back in 2007 when it yielded 4.6%. Yields have fallen and therefore prices risen to the extent that selling now would realise a good capital profit (of about 75%, in fact) but leave investors forced to re-invest at the current yield to the same maturity of just 1.2%, inadequate for a pension fund. The one-off capital gain is welcome, but does not make up for pension funds' preference to own bonds returning regular higher returns that can pay retiree benefits, not even if the Bank is prepared to pay over the current market odds for them.

So too with insurance companies. Quoting Gareth Haslip of JPMorgan Asset Management: "When they sell annuities, they look to match the liabilities with long-dated cash flows (i.e. income from gilts) ...... The insurers aren't really trying to profit from the gilts, they just want to be immunised from interest rate risk". So far, so repetitive perhaps ..... but there are regulatory issues at play too. Regulators have reinforced the pressure to hang onto gilts not only by increasing the amount of capital required to meet liabilities but also by demanding more of it if the assets and liabilities are not closely linked  --  or in other words, the assets are not gilts.

Anyway, that's the perceived wisdom as to why the Bank struggled to find enough long bonds on Tuesday. On the face of it, it doesn't bode well for future attempts to repeat the process but not everyone's overly concerned, citing quiet holiday conditions for the shortfall. Certainly that's the BoE's stated interpretation of events. We may well know more on Tuesday, when the Bank goes into the market once more for long-dated stock. Of course, the Treasury is selling £1.25bn of 2055 debt the day before so there's a good chance of some switching going on  --  buying the issue on Monday from the Treasury with a view to selling it to the BoE on Tuesday.

We can expect another sharp downward reaction in yields if the Bank fails to fill its buying boots on Tuesday, or has to pay way over the top to do so. But of course, pushing down long-term borrowing costs is ultimately the point of QE  --  even if it's a bit of a nightmare for those pension funds and insurers.