Friday, 7 August 2009

The Bank of England has cornered the gilts market

The surprise decision by the Bank of England yesterday to increase the ceiling on its Quantitative Easing (QE) program to £175 billion caught many City slickers by surprise and there was an immediate drop in sterling (as seen in the chart above) and an equally abrupt drop in yields in the gilt market.

It turns out that the QE program exactly matches the government's projected deficit this year - or at least the figure that Chancellor Darling last gave to Parliament - and further research shows that in effect the Bank of England now owns the majority of outstanding gilts and has "cornered the market" in Treasuries as this piece from the Daily Telegraph reveals.

So much of the gilts market does the Bank now own that, in a landmark move, it also agreed that it would temporarily lend out gilts through the Debt Management Office to ensure that banks are able to close out positions as necessary.

The Bank has also suspended its purchases of four particular maturities of gilts after it emerged that it had bought as much as 70pc of their total issue. In a further sign of the rate at which it is exhausting the gilt market, the Bank will also start buying gilts of both shorter and longer maturities than the 5 to 25 year set it was originally buying.

Danny Gabay of Fathom Consulting said the news "reflects the fact that the Bank has to all intents and purposes 'cornered' the market for certain Gilts or bonds, to which market participants may still need to have access. Innocent enough - but it makes the charge that the whole [scheme] is an elaborate smokescreen for monetising the government's ballooning deficit even harder to refute.

"So, while we welcome the news of an extension to the asset programme, we would once again urge the MPC to consider a much wider range of assets to purchase than government bonds."

Yesterday's decision means that the Bank will soon own almost half of the entire gilts market, currently worth around £400bn, raising further questions about the Government's reliance on the QE programme to keep its financing under control.

The worrying question must surely be -- what about next year's projected deficit which according to the Chancellor is about the same as this year's i.e. £175 billion?

Will the Treasury be able to sell gilts to anyone other than the Bank of England?

Some cynics of my acquaintance are even asking whether this system of completing the daisy chain between the Bank's printing press and the funding of the public finances needs a new moniker as Ponzi scheme doesn't quite fit the bill.

On a cautionary note there will be few wanting to short the gilt market as they will in effect have to ask the Bank of England to lend them the security so they can sell it back to them where the Bank effectively runs the market . We may also need some new terminology to augment our notions of repos and reverse repos.

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