Bank of England is now also buying inflation-linked bonds

The BoE’s announcement that it would start buying inflation-linked bonds sent the pound lower again. The British currency fell as much as 0.5 percent to $1.0996 on Tuesday morning.

The central bank wants to invest up to 10 billion pounds in government bonds every day until the end of this week. The maximum amount is now divided equally between long-dated government bonds and inflation-linked bonds.

Intervention by the Bank of England in the market for inflation-linked bonds is considered unusual by experts. “It all seems pretty chaotic and panicky,” said Neil Wilson, chief analyst at online brokerage Markets.com. The BoE will certainly have to intervene more often to prevent worse things from happening. The uncertainty surrounding Prime Minister Liz Truss’ economic policy plans threatened to do “permanent damage” to the British government bond market,” according to a study by the US bank JP Morgan.

Central bank sees risk to financial stability

The central bank itself warned of the risk of a financial crisis: “At the beginning of this week there was another significant revaluation of British government bonds,” it said in a statement on Tuesday. “The dysfunctionality of this market and the prospect of self-reinforcing distress sale dynamics pose a significant risk to the financial stability of the UK.”

Already on Monday, another sell-off in British bonds had caused turmoil in the financial markets worldwide. This pushed the 10-year UK government bond yield back towards its 14-year high of 4.582 percent set in late September. At that time, the central bank had to intervene with support purchases for the first time because pension funds threatened to get into trouble as a result of the development.

Inflation-linked bonds were hardest hit by the bond market sell-off at the start of the week, with 10-year bond yields rising 64 basis points, the highest since data began in 1992. The rise in inflation-linked bond yields was more than double the rate with conventional bonds.

Prime Minister under pressure to justify herself

Analysts and economists see the market turbulence as a vote of no confidence in the budget policy of the new government under conservative Prime Minister Truss. She and her finance minister, Kwasi Kwarteng, had announced a comprehensive tax and economic package that caused great concern on the financial markets about escalating government debt and uncontrollable inflation rates.

Commerzbank analyst You-Na Park-Heger pointed out that the actual problem, the doubts about the financeability of the new British government’s relief package, would not be solved by the central bank’s purchase of inflation-protected bonds. “The government shows no willingness to make real concessions, and it remains to be seen whether Chancellor Kwarteng will be able to convince the markets at the end of the month with his financial plan in relation to the sustainability of public finances.”

>>> Also read: Liz Truss is under pressure after tax policy U-turn

A few days ago, Truss and Kwarteng had to say goodbye to a central point of their economic policy after severe turbulence on the markets and massive resistance from their own party. At the Conservative Party Conference, the Prime Minister and her Finance Minister reversed the controversial abolition of the top income tax rate of 45 percent.

budget deficit

However, this step could not allay concerns about the new government’s economic policy. The think tank Institute for Fiscal Studies (IFS) has calculated that even after plans for the top tax rate are scrapped by 2026, there will be a gap of £60 billion in the British government budget.

The reason for this shortfall is the Truss government’s other tax relief plans and the turbulence in the bond market, which are worsening the financing conditions for the state. According to the economic researchers, the finance minister’s growth assumptions are far too ambitious.

In its budget planning, Kwarteng assumes that the British economy will grow by an average of 2.5 percent in the coming years. The IFS, on the other hand, considers a rate of 0.8 percent to be realistic at most.

IFS Director Paul Johnson believes it is technically possible that Kwarteng can balance the budget through savings by 2026, but points out that the public sector has already shrunk significantly in recent years. Johnson sees “not much room left” for further cuts.

According to calculations by the IFS, the British government will still have to borrow 100 billion pounds on the markets in 2026. Earlier calculations from the time before the Conservatives’ new draft budget had put the financial requirement at around £30 billion.

fear of loss of trust

Craig Veysey, portfolio manager at wealth manager Man GLG, says: “Many investors have lost faith in the UK government and its underfunded tax program.”

So far, the Bank of England has announced an end date of October 14 for its bond purchase program to support the market. But Veysey fears that this time limit could lead to further problems in the markets. The central bank may need to show more flexibility to avoid further upheaval.

According to Wes Wilkes, chief executive of wealth manager Ironmarkets, “it would probably be naïve to expect an orderly end” to the stimulus program. “The British government has put the central bank in a very difficult situation,” warns Wilkes.

Normally, support purchases would have a calming effect on the markets, but at the moment they “just seemed desperate”. “The whole thing is a farce,” is Wilkes’ unoptimistic conclusion.

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