- The Bank of England plans to buy as many government bonds as needed to stabilize markets.
- News of the UK government's spending plans tanked the pound and sent long-term bond yields skyward.
- Here's why the BoE is taking action, and what it means for investors and markets.
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The Bank of England announced on Wednesday that it will temporarily buy as many UK government bonds as needed to stabilize debt markets, and delay the start date for its bond sales. Here's what's going on, and what it means.
A dramatic rise in yields for long-dated UK government bonds (gilts) has spurred the BoE to intervene before a financial catastrophe happens.
The new UK government on Friday outlined its plans to stimulate flagging economic growth by cutting taxes and scrapping the cap on bankers' bonuses, along with energy bill subsidies for households. The measures will be debt-funded to the tune of 45 billion pounds ($48.3 billion).
The proposed policies rattled investors' confidence in the UK's stability, and the British pound dropped to a record low against the US dollar on Monday.
They also drove a rise in two-year UK government bond yields to a 14-year high of 4.3%, and pushed the yield up on 10-year benchmark gilts to 4.1% on Tuesday.
A weaker pound makes imported goods more expensive, while higher gilt yields raise the cost of government borrowing.
"Were dysfunction in this market to continue or worsen, there would be a material risk to financial stability," the BoE said Wednesday.
The central bank explained that if yields were allowed to climb higher, that could cause "unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy."
In other words, higher government bond yields could cause 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-dated government bonds for about two weeks, from September 28 until October 14.
It will carry those out at "whatever scale is necessary" to stabilize markets, and the costs will be covered by the government, it said.
After the announcement, 10-year gilt yields fell 43 basis points to 4.08% at last check, after closing at 4.51% on Tuesday. But they're still up sharply for the year, having traded below 1% at the start of January.
The BoE's financial policy committee recognized the market risks, recommended an intervention, and welcomed the plan to buy bonds "at an urgent pace", it said.
The bank will carefully unwind the purchases once it's confident that market conditions have returned to normal.
At the same time, the BoE will delay the start of its quantitative tightening (QT) program, where it sells government bonds to cool the economy. It will begin October 31, rather than next week as planned.
However, it still plans to hit its target of a $80 billion reduction in its bond holdings over the next 12 months.
What does the BoE plan mean for investors and markets?
The Bank of England's temporary bond-buying is designed to calm investors' fears that lower taxes and more government spending will accelerate inflation, which is already close to four-decade highs. That should prevent further selloffs driven by those concerns.
However, quantitative easing (QE) stimulates economies by injecting more liquidity into them. The government effectively prints money to buy bonds on the open market, increasing the total money supply and providing more cash for people to spend and invest.
The BoE is betting that a brief stint of bond-buying won't be enough to spike inflation, but it will be sufficient to calm markets.
It also hopes to prevent bond yields from climbing higher, which would increase the government's borrowing costs and make funding its fiscal programs more onerous — and potentially add to its debt pile. Plus, it wants to forestall a credit crunch in the real economy.
Still, buying bonds risks undermining the BoE's ongoing efforts to crush inflation by raising interest rates, as one program is expansionary and the other is contractionary. The International Monetary Fund warned the UK government not to pursue its aggressive spending plans for the same reason on Wednesday.
Overall, the planned bond purchases could make inflation worse and undermine what the BoE is trying to achieve via its rate hikes. That would mean more rate hikes are needed, and the risk of a recession would grow.
However, they could also restore order to chaotic markets and prevent a nationwide credit crunch.