Linker Madness Forces Bank Of England Further Down Rabbit Hole

LDI funds in the UK “have made substantial progress” over the past week in addressing “risks to their resilience from volatility in the long-dated gilt market,” the Bank of England said Tuesday, a day after unveiling a new “temporary” repo facility designed to “support market functioning” and facilitate an “orderly end” to its emergency gilt-purchase scheme.

Already, you’ll note the inherent absurdity. The BoE on Monday reiterated that it plans to end the “temporary” emergency buying of long-dated gilts as scheduled on Friday, but recognizing the potential for additional turmoil tied to the cessation of central bank support, officials launched another facility. So, a “temporary” repo facility is necessary to safely exit “temporary” long-dated gilt buying.

That wasn’t all. The BoE also said it would, if necessary, deploy the balance of unused purchase capacity from the eight auctions held since the onset of emergency purchases late last month. In other words: They upsized the daily limits on the final five auctions on the excuse that the first eight weren’t maxed out.

Fast forward to Tuesday and the BoE had to “widen the scope” of its daily purchase operations to include linkers because, as the bank put it, in yet another news release, “the beginning of this week has seen a further significant repricing of UK government debt, particularly index-linked gilts.”

“Dysfunction in this market, and the prospect of self-reinforcing ‘fire sale’ dynamics pose a material risk to UK financial stability,” the BoE warned, in no uncertain terms.

If you’re wondering what linker dysfunction looks like, the figure (below) is instructive. Or not. It’s just another nonsense chart out of the UK. A total debacle, for lack of a more polite way to put it.

The bank is “mopping up the selling of index-linked gilts that exceeds the market’s immediate capacity,” SPI Asset Management’s Stephen Innes said. “The linker market is niche, but reflects the continued unwind of leverage and portfolio rebalancing.”

ING was very direct: “The BoE is clearly playing gilt selloff Whac-a-Mole,” the bank’s Antoine Bouvet remarked.

As regular readers will attest, I’ve variously insisted that the turmoil in the UK pension complex isn’t over, and, more broadly, that the BoE will end up forced to support gilts further by, for example, pledging to keep buying bonds as necessary until the pressure well and truly subsides. I’m glad I was adamant about that, because it was borne out on Monday and Tuesday.

I assume the BoE and Treasury have some idea about when the LDI unwind will run its course, but then again, recent events don’t inspire much confidence in the level of preparedness among UK officials. And, ultimately, the point of contention for markets hasn’t been addressed. The ongoing turmoil is the result of a perilous combination: A central bank pulling support for government debt at the same time the government is borrowing to pay for unfunded fiscal initiatives, including tax cuts and an energy price cap that’s tantamount to an uncapped liability.

Reuters described Tuesday’s linker intervention (and the associated language employed by the BoE) as “another embarrassment for Liz Truss.” The same article helpfully reminded investors that Truss’s economic agenda is the proximate cause of “a collapse in international investor confidence towards British assets.”

As I suggested on October 5, the market won’t stop testing the BoE. These are, after all, just Band-Aids. On bullet wounds. “Consistently acting at the last minute without putting a more credible long-term plan in place is unnerving for markets,” ING’s Bouvet went on to say.

Make no mistake, the BoE’s latest intervention does amount to an expanded backstop. If you ask Bloomberg Economics, “it’s more likely than not that the central bank will have to commit to intervening in the bond market where necessary beyond October 14.”

One fixed income strategist who spoke to Bloomberg News on Tuesday said simply, “I think QT is over.”

Right. Of course it is. But please don’t lose track of the punchline: It never started. When the BoE launched its “temporary” long-dated (conventional) gilt purchases late last month, they pushed out the start date for QT until the end of this month. Now, they’re in linkers, and warning (publicly!) about “self-reinforcing ‘fire sale’ dynamics.”

The LDI debacle may get incrementally better (because the only way it could get worse is if the entire pension complex implodes). That said, an industry group suggested the bank extend its bond-buying at least through the end of this month, if not longer. That’s a self-serving plea, but one surely born of genuine concern.

On Tuesday, the BoE insisted that “All purchases will be unwound in a smooth and orderly fashion once risks to market functioning are judged to have subsided.”

You can draw your own conclusions about that. At the tail end of Tuesday’s news release, the bank said it’s “pausing” the unwind of its corporate bond holdings. “Temporarily,” of course.