What happens when Quantitative Easing (QE) meets an illiquid market? It looks as if the Bank of England just found out.
As part of the BoE’s new £70 billion stimulus program, designed to offset any concerns investors may have about the effect of Brexit on the UK’s economy, the BoE announced last week that it is going to acquire a further £60 billion of UK gilts.
The first auction in this latest wave of central bank easing took place on Tuesday of this week, but it seems that market participants aren’t as willing to participate in the program as the BoE’s policymakers first interpreted.
A lack of buyers
The Tuesday auction was targeting £1.17 billion in long-term gilts, but the final tally fell well short of this objective, 4% short in fact, and the central bank had to pay a hefty premium on market prices to acquire the bonds it did manage to get.
This auction failure has shown the world what happens to bond prices when a central bank literally runs out of bonds to buy — something that might become increasingly common as both the European Central Bank and Bank of Japan continue their monetary easing.
Bank of America’s credit analyst, Hans Mikkelsen weighed in on the bond market price action in a research note to clients almost immediately after the BoE’s auction failure:
“… yields plunge. Today’s Bank of England (BOE) reverse auction showcased that as they fell 4% short on their plan to £1.17bn long term gilts, and had to pay below–market yields for the bonds they got. While we would not read too much into the implications for sovereign yields, clearly today – for whatever reason – the gilt market had insufficient liquidity to provide the BOE the amount of bonds they were looking to buy using their preferred mechanism. However, we do think that the immediate decline in yields (4bps on the UKT 4% ‘60s for example) showcases why corporate bond QE is so bullish for credit spreads. When central banks want to buy in size in an illiquid market, such as the corporate bond market, they have to pay up significantly to even try to fill their desired size. This is true regardless of whether the pricing mechanism is BOE’s preferred reverse auction or the ECBs bilateral negotiations.”
QE: Holders are not willing to sell
Hans Mikkelsen doesn’t speculate why the BoE’s auction failed to meet its target but Financial Times journalists, Elaine Moore and Josephine Cumbo write, it is believed that pension funds and insurance companies refused to sell enough gilts to the central bank to meet its purchase target. In monetary terms, the shortfall totaled £50 million, and to make up the difference the BoE is planning to extend the QE program.
However, according to the FT, which cites comments from investors, the BoE could run into the same illiquidity problems at its next auction of long-dated gilts as UK pension funds struggle to grapple with severe funding mismatches.
Photo by The Lakelander