Oh God, they’re writing about gilts again.
Reader, we’re as unhappy as you are, but gilts have a problem. Again. Thankfully, it’s not a problem at the scale of ‘the-waking-nightmare-that-will-follow-Kwasi-Kwarteng-for-the-rest-of-his-life’, but still a problem.
The issue is short-end gilts: there just ain’t enough to go around.
This has been creating issues all year but seems to have got worse in recent weeks following gilts’ unwelcome spell as the main character in financial markets.
The discrepancy is visible in the spread between RONIA — the index of overnight gilt repo — and the official Bank of England bank rate. Basically, markets appear willing to accept a lower yield just to get their hands on some of that sweet high-quality, short-term paper:
Compare and contrast with the US:
Or, from Andrew Bailey’s point-of-view:
As ING’s Antoine Bouvet put it in a note last week:
It is becoming increasingly difficult to buy short-dated gilts, or to borrow them via repurchase agreements (repo). The crisis has been brewing for some time due to increased market volatility and investors’ risk aversion, but it worsened when pension funds and other market participants decided to increase their liquidity holdings in anticipation of the September/October gilt crisis. This abundance of liquidity is typically used to buy safe short-dated securities, such as gilts, or lent out against high-quality collateral on the repo market.
There are a couple of reasons why this is a bad thing if you’re the BoE,
— If the money markets aren’t working properly, people may be disinclined to use them (bad because part of your job is to make markets function)
— If the money markets aren’t working properly, your efforts to increase interest rates are not going to be transmitted properly (bad because you are the BoE)
The BoE, to its credit, is aware of the problem — and it’s been deliberately tilting the initial gilt sales in its quantitative tightening programme towards the short end (3 years is the shortest they currently go). Sir David Ramsden discussed this after last Thursday’s interesting rate decision, per Bloomberg:
“We deliberately skewed the sales to the short- and medium buckets so we can support the market by providing collateral,” Ramsden told a press conference, speaking after the BOE’s interest rate move.
He added that given the potential for concerns at the long-end of the gilt curve, “we thought we can start selling from the longer end of our holdings in the new year.”
This “here’s one I made earlier” approach has its limitations, however, as Bailey admitted at the same press conference (“sales are not going to have that much impact in that sense”).
Thankfully, Alphaville is super into news you can use, and NatWest’s Imogen Bachra dropped into our inbox yesterday with some potential solutions (we were working on an important project at the time). She says: “although we are not yet at levels which have forced the BoE to step in, we may not be far away”.
Bachra’s ideas, condensed for your pleasure in order of descending likelihood:
1) Do nothing
“This has been the preferred option so far, although we are now approaching levels of stress (measured by swap spreads, or the difference between overnight repo and SONIA) not seen before… If a policy announcement was imminent, we would expect more noise to be made about this. Indeed, those measures of “stress” have calmed, somewhat, since the BoE meeting last week, which might take some of the immediate pressure off the BoE. It remains to be seen how durable this market reversal is, however. ”
Apologies if you were hoping the most likely one would be something more exciting than ‘do nothing’.
2) Get Feddy with it
“The US has a proven mechanism that works as a floor in repo markets and therefore protects the transmission mechanism of monetary policy… The BoE could easily “copy-and-paste” a similar mechanism (tweaks are possible, like making it more limited in terms of size and time), which would immediately make available all the front-end bonds that currently sit on its balance sheet.”
Bachra reckons when an intervention comes, this is how it’ll look.
3) More QT:
“In structuring any potential additional sales, the BoE has two options: either increasing the size of the short bucket (ie from 3-7y to 1-7y, say) or introducing a whole new bucket into the auction schedule (ie adding in sales of 1-3y). We think the latter is more likely, as extending the maturities of the existing bucket could serve only to push scarcity issues further up the curve and cannibalise sales of 4-7y paper.
Increasing sales vs introducing a temporary repo mechanism has the advantage of shrinking the balance sheet quicker at a time when there is sufficient demand to absorb the additional sales… That said, selling more shorts will alleviate collateral scarcity only very slowly at the pace the BoE is likely to conduct sales.
4) Try a little tenderness
The BoE could start a bill programme, thereby creating the collateral needed in the system, but also alleviate some of the need for (or calls for) a tiered rate on reserve remuneration… We think this is unlikely to be preferred to just selling the short-dated gilts it owns outright, however, and the BoE may be reluctant to create a systemic dependency on BoE bills over the longer-term.
There you go, plenty of options. Wake us up if it breaks again.