Why Would The Bond Vigilantes Spare The Bank Of England?

Since announcing an emergency bond market intervention last week to prevent the UK pension complex from collapsing, the Bank of England hasn’t had to buy that many long-dated gilts.

The narrative goes something like this. Because the emergency program hasn’t been maxed out, the BoE was successful, markets are now calm and therefore the purchases will be easy to unwind, as stipulated in the original announcement.

Forgive me, but that’s laughably naive. The old “If they know we have overwhelming firepower, we won’t likely have to use it” strategy doesn’t work as well when you tell the “enemy” the exact day you plan to pack up the guns and leave the castle. Just ask Kabul.

When it comes to gilts, I’d gently suggest the vigilantes might’ve simply fallen back to the tree line out of respect for the newly-mounted Gatling guns on the castle turrets. As soon as they’re removed (so, on October 14), the barbarians may well be right back at the gates.

Ostensibly, the BoE can mow them down again, just like the US could doubtlessly recapture Kabul from the Taliban if the Pentagon decided to commit the full force of the US military to the effort. But that’s not a viable strategy for the BoE. Gunning down the vigilantes entails either i) conjuring a limited amount of reserves with the express intent of actually buying bonds over a limited time frame or ii) committing to the open-ended conjuring of reserves with no specified end date on the assumption that doing so will discourage the barbarians and thereby obviate the need to actually buy gilts. The former strategy (which the BoE adopted last week) caps money-printing but risks a renewed rise in yields once the program expires. The latter strategy is a gamble because if the barbarians call your bluff, you’ve committed yourself to money-printing in perpetuity.

Let me spell this out as clearly as possible. The problem for Andrew Bailey is threefold.

First, the BoE hasn’t just promised to sell the long-dated gilts it’s buying as part of the emergency intervention, but also £80 billion more over 12 months as part of the bank’s efforts to actively shrink its balance sheet. To extend the castle analogy, the BoE has effectively promised to come down from the turrets and join the barbarians in sacking the castle. Depending on what’s needed in terms of issuance to fund fiscal spending, the total amount of gilt supply to the private market over the next 18 months assuming simultaneous BoE QT could exceed that seen over the previous four and a half years! 

Second, if the BoE were to commit to an open-ended defense of gilts with no expiration date and the market tests the bank’s resolve, Bailey would be in a very dangerous position: Caught between uncapped money-printing or conceding defeat. The former risks undermining the currency and thereby further pass-through inflation and trade shocks, and the latter a total collapse of the UK bond market. The Bank of Japan is currently facing the same predicament. And look what’s happened to the yen. An open-ended commitment from the BoE on long-dated gilts would just be yield-curve control without a specific cap. Every day would be a kind of exploratory stop-run. Although Kuroda is still holding on, don’t forget that the vigilantes smoked the RBA out of their own YCC regime with what even the bank admits are unknowable long-term credibility consequences.

Third, if the BoE postpones QT indefinitely (perhaps the least bad option), everything else suddenly becomes a glaring contradiction. If they postpone their QT plans, that’d be directly contrary to the language employed in last week’s intervention announcement. But more importantly, it’d immediately transform the (small) amount of long-dated gilts they just bought under the emergency program into balance sheet-expanding QE purchases. There’d be no point in selling them (they’re too small to matter) and if they tried, markets would immediately point to the contradiction inherent in claiming to have postponed QT only to turn around and offload bonds. At the same time, the suspension of QT combined with the expansion of the balance sheet (however minuscule), would make for a cartoonish juxtaposition with what are expected to be draconian rate hikes to help mitigate the expected long-term inflationary consequences of Liz Truss’s growth plan.

Importantly, I’m not saying this will invariably end in some kind of catastrophe. A lot depends on the evolution of the macro backdrop over the next month, how Truss manages the ongoing fallout from last week’s highly unfortunate market events and whether traders are inclined to push the issue, which is in turn a function of how easy a target they think the BoE is.

What I am saying, though, is that we shouldn’t be naive about this. And we shouldn’t downplay the vexing nature of the BoE’s dilemma. My contention is that they’re cornered. They need a deus ex machina, and I don’t see where it’s going to come from. Absent that, they’re effectively hoping legions of vigilantes who spent the last dozen years laboring under the oppressive thumb of arrogant policymakers will inexplicably be inclined to show mercy with their tormentors on the ropes.