Why the Bank of England is buying bonds to prevent a financial disaster

  • The Bank of England plans to buy as many government bonds as it needs to stabilize markets.
  • News of the UK government’s spending plans boosted the pound and sent long-term bond yields soaring.
  • Here’s why the BoE is taking action and what it means for investors and markets.

The Bank of England said on Wednesday it will temporarily buy as many UK government bonds as it needs to stabilize debt markets and delay the start date of its bond sales. Here’s what’s happening and what it means.

What happened?

A dramatic rise in yields on long-term UK government bonds (gilts) prompted the BoE to intervene before a financial disaster struck.

The new UK government on Friday outlined plans to boost economic growth by cutting taxes and scrapping the cap on bankers’ bonuses, along with subsidizing household energy bills. The measures will be financed with 45 billion pounds ($48.3 billion) of debt.

The proposed policies shook investor confidence in UK stability and the British pound fell to a record low against the US dollar on Monday.

They also pushed two-year UK government bond yields to a 14-year high of 4.3%, and pushed the yield on benchmark 10-year gold to 4.1% on Tuesday.

A weaker pound makes imported goods more expensive, while higher gold yields raise the cost of government borrowing.

“If the dysfunction in this market continues or worsens, there would be a significant risk to financial stability,” the BoE said on Wednesday.

The central bank explained that if yields were allowed to rise higher, this could cause “undue tightening of financing conditions and a reduction in the flow of credit to the real economy”.

In other words, higher government bond yields could trigger a credit crunch, making it more expensive and difficult for households and businesses to borrow money.

The bank’s solution? Temporary and targeted purchases of long-term government bonds for approximately two weeks, from September 28 to October 14.

It will carry these out on “whatever scale is necessary” to stabilize markets and the cost will be covered by the government, it said.

Following the announcement, 10-year gold yields fell 43 basis points to 4.08% at last check, after closing at 4.51% on Tuesday. However, they are still sharply up for the year, having traded below 1% in early January.

The BoE’s financial policy committee recognized market risks, recommended intervention and welcomed the plan to buy bonds “at an urgent pace”, it said.

The bank will carefully unwind markets once it is satisfied that market conditions have returned to normal.

At the same time, the BoE will delay the start of its quantitative easing (QT) program, where it sells government bonds to cool the economy. It will start on October 31st and not next week as planned.

However, it still plans to meet its target of $80 billion of debt reduction over the next 12 months.

What does BoE’s plan mean for investors and markets?

The Bank of England’s temporary bond buying is designed to calm investor fears that lower taxes and more government spending will accelerate inflation, which is already near four-decade highs. This will prevent further discounts due to these concerns.

However, quantitative easing (QE) stimulates economies by injecting more liquidity into them. The government essentially prints money to buy bonds on the open market, increasing the overall money supply and providing more cash for people to spend and invest.

The BoE is betting that a short period of bond buying won’t be enough to boost inflation, but it will be enough to calm markets.

It also hopes to prevent bond yields from rising, which would raise the government’s borrowing costs and make financing its fiscal programs more onerous – and potentially add to its debt pile. In addition, he wants to prevent a credit crunch in the real economy.

However, the bond market risks undermining the BoE’s ongoing efforts to crush inflation by raising interest rates, as one program is expansionary and the other contractionary. The International Monetary Fund warned the British government against pursuing aggressive spending plans for the same reason on Wednesday.

Overall, the planned bond purchases could worsen inflation and undermine what the BoE is trying to achieve through its rate hikes. This would mean more rate hikes are needed and the risk of a recession would increase.

But they could also restore order to chaotic markets and prevent a nationwide credit crunch.

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