Inflation-linked gilts come unlinked

[kiwi2007]

Oct 11, 2022, 11:06 PM
UK rather than NZ but concerning non the less

Opinion  Unhedged

Inflation-linked gilts come unlinked
FT

UK 10-year inflation-linked gilt yields rose 64 basis points yesterday, hitting 1.24 per cent. This is an absolutely bonkers move. In price terms, the 10-year linker fell 5.5 per cent; developed world sovereign bonds are not supposed to move like that (the 30-year linker was down 16 per cent on the day).

At the same time, very strangely, nominal 10-year gilt yields rose by much less — 23bp. In a brief story, our friends at Bloomberg noted that the move in linkers was the largest since at least 1992, and said the move was driven by "concerns over market frailties ahead of the Bank of England ending its bond-buying operations". That sweepy phrase seems to mean "we don't really know what is going on here". Unhedged sympathises; we don't really know what is going on here, either. All we can offer are the following thoughts:

Economic fundamentals cannot explain this move. In a liquid and efficient market, index-linked bonds would be a proxy for the real rate of interest. The real rate of interest in the UK did not double yesterday. Also, in a liquid and efficient market, nominal bond yields minus inflation-linked bond yields is proxy for inflation expectations. Ten-year inflation expectations did not fall by 40bp yesterday.

This move is partly to do with liability driven investment strategies at pension funds. The very rapid rise in yields which followed the Liz Truss/Kwasi Kwarteng "mini" Budget announcement left LDI investors with big losses on their rate hedges, forcing them to sell gilts to raise cash. LDI investors own a lot of inflation-linked gilts, as well, and have been forced into selling them. But there is a crucial difference: the Bank of England is not buying inflation-linked gilts as part of its temporary market stabilisation programme. Given that the inflation-linked market is relatively thin to begin with, the presence of forced sellers in the absence of a buyer of last resort adds up to an ugly day.

While not as wild as the move in linkers, the move in vanilla gilts is a big deal, too. As the FT reported:

Monday's fall in gilts came despite the BoE announcement earlier in the day of a new short-term funding facility to avoid a "cliff edge" when the central bank's £65bn emergency bond-buying programme ends this week.

On a day when the UK government also sought to reassure markets by bringing forward the date of a debt-cutting plan, the 30-year gilt yield jumped 0.29 percentage points to 4.68 per cent. The gilt market has been unsettled since the government announced unfunded tax cuts last month.

The BoE announced yesterday that it was raising the upper limit of its daily purchases of long-dated bonds from £5bn to £10bn. It also announced a temporary repo facility "to enable banks to help ease liquidity pressures facing their client LDI funds". The facility allows banks to borrow using a range of securities, including index-linked gilts, as collateral. The idea is that the banks will be able to act as intermediaries for LDI investors who need to raise cash. Neither move worked. As of Monday, the long end of the curve was clearly out of the BoE's control.

We don't yet know why the bank's interventions have not worked (we're trying to talk to more of the people involved). But there is something odd about the fact that, before yesterday, the bank had a cumulative purchase ceiling of £40bn, and had purchased only £5bn in bonds. Yesterday, it set a daily limit of £10bn and bought just £853mn — while bond prices were crashing. We don't know the details yet, but from the outside, this sure looks like a halfhearted intervention, not so much yield curve control as politely asking the yield curve, if it wouldn't mind terribly, to behave itself, just for a few days? Please?

Unhedged is still a little puzzled about how all of this got started and why it is all so bad. There was a simple narrative when the "mini" Budget was announced and the market recoiled. Fiscal deficits were going to rise. That meant the supply of gilts would increase, pushing their prices down. What's more, the budget implied an odd combination of tight monetary and loose fiscal policy. This, along with some general clowning around with the budget process, meant that the extreme market moves could be explained by the loss of credibility, or, if you prefer, a widening risk premium on UK gilts. But the fact that much of the fiscal programme has now been rowed back, and the market is still not pacified, suggests there is more to this story. Part of this is the LDI funds puking bonds into the market. Part of it is the simple fact that the global policy tightening cycle impairs liquidity and risk appetites. But Unhedged suspects there is something more going on.

That something more may be international. Bund yields moved 15bp yesterday, too.

This story ain't nearly over.

FT

And volatility in linkers continues this morning UK time. All this instability a bit concerning.
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[kiwi2007]

Is the UK the canary in the coal mine? I dunno but I'm shopping for an extra pair of swimming trunks, just in case.


   https://www.ft.com/content/a01b1f79-710c-4b3a-8be4-c040c683225c

Megan Greene    The writer is an FT contributing editor and global chief economist at Kroll

As the era of cheap money comes to an end amid a global central bank tightening cycle, UK pension funds have been among the first bodies to float to the surface. I am certain they will not be the last. Margin calls sparked by the funds' liability-driven investing (LDI) forced the Bank of England back into quantitative easing. And on Tuesday the BoE widened its bond-buying programme, warning of a "material risk to UK financial stability".

The troubles brought on by Chancellor Kwasi Kwarteng's "mini" Budget are a harbinger of unfortunate events to come across developed markets in the next year. Governments will spend more; investors will be the dominant disciplining force; and central banks will break other things in trying to break the back of inflation.

Even as monetary authorities withdraw liquidity, war and the energy crisis will require developed markets to spend much more in the coming year. ...................>


<.........Price moves in the next year will be as swift and dramatic as they have been in the UK partly because markets are already highly stressed. The global central bank hiking cycle has tightened financial conditions and sapped liquidity. This is not a bug. It is the point of hiking rates. But as central banks continue hiking, something will probably break.

 Bank of America announced its gauge measuring stress in credit markets was at a "borderline critical level". ........>

<..........What, then, is likely to break? Post-financial crisis, big US banks are much better capitalised. That is not always true in Europe. And on neither continent can regulators be confident about what lurks in the shadow banking sector. Even very liquid assets — such as gilts in the UK — may be a source of trouble. Investment grade corporate debt is an issue for the US. .........

Another body to float to the surface in this tightening cycle may be alternative assets, including private equity and debt. .........

The UK's experience reminds us that central banks have a very fine line to walk between fighting inflation and supporting financial stability. After years of bailouts, investors seem to be ignoring "this time we mean it" warnings and betting on a pivot. At the same time, governments forced to spend will be working at cross-purposes to the inflation fight. Opec+ has decided to pile on by cutting supply and raising energy prices again. Given oil is largely priced in dollars, the dollar remains the US currency, but the world's problem. Market dislocations alone will not be enough for central banks to U-turn and cut rates. A financial crisis that kicks off a recession would, but that would be the worst possible way to lick inflation.

[mcdongle]

Yes the UK Pension funds margin calls have made things "interesting" and its not over yet.

[arekaywhy]

the joys of ponzi schemes