Gilt market problems aren’t unique to the UK

The Bank of England recently announced that it would enter the market to buy government bonds (known as gilts) with a remaining maturity of 20 years or more. Although the central bank insists that its actions are “temporary,” to restore “orderly” markets, it’s not really clear what either of those words mean. 1 It was only on Sept. 21 that it announced plans to shrink its balance sheet assets by auctioning some of its gilt holdings. It looks like the bank’s follow-up action was to rescue some UK insurance and pension funds, which were facing hundreds of millions of pounds of margin calls as the value of their bond holdings declined – margin calls that some would surely struggle to meet.
That the BOE acted swiftly is to its credit. But the questions about what happened in recent days run deep, are far from relevant only to the UK and are most certainly not over.
The proximate cause of the run on UK government bonds and sterling was the government’s rather bold plan, announced on Sept. 23, to cut taxes without any attempt at cost savings or the slightest nod to fiscal probity. Small wonder, perhaps, that gilt yields climbed like the proverbial homesick angel and sterling collapsed. At one point, two-year inflation-linked bonds fell 8% in value from their high in late August. Apart from an emerging-market default, I cannot remember any short-dated bond moving that much over such a short period of time: they move not in percentage points but in hundredths of a percentage point. Long-dated inflation-linked gilts collapsed by almost 75% from their highs in December. Conventional 30-year gilts tumbled by some 60% over the same period.
The resulting problems for pension funds were twofold. First, to offset liabilities they had bought long-dated gilts (and probably some long-dated inflation-linked bonds) via counterparts who held those positions for them. Second, because the UK market is relatively small, they had also bought fairly low-quality investment-grade credit in the US and swapped these exposures into sterling. That left them with a dollar short position on one leg of the swap. Both types of trade were done via counterparts who demanded collateral — lots of it. Often, that meant selling other assets, hence the vortex of the past few days which the BOE has, rightly, alleviated by its actions. I am not sure that this is the end of the story.
For a start, the acute problems that have beset UK assets afflict other countries too, albeit in less visible and more chronic ways. The differences, I would suggest, are ones of degree not of kind. Other European countries, after all, have put energy caps of one sort or another in place, thereby loosening fiscal policy.
—Bloomberg