The Bank of England announced that it would buy £65 billion worth of U.K. government debt on Sept. 28 after a sell-off by pension funds turned into a fire sale. The bank's move raised expectations that central banks around the world would also be pulled back into bond markets. Source: Getty Images Europe |
Global central banks may be facing their own versions of the Bank of England's recent bailout of the U.K. government bond market as liquidity shortfalls reveal cracks in financial markets.
The U.K.'s central bank was forced to stabilize the market for gilts — the country's government debt securities — just a month after announcing it would unwind the $1 trillion balance sheet it built up during the pandemic. Meanwhile, the Federal Reserve and other global central banks have begun reducing their record-breaking balance sheets to combat soaring inflation, which followed the pileup of trillions in bond purchases since 2020 to keep those markets afloat and borrowing costs low as the world reeled from the effects of the COVID-19 pandemic.
As the Fed and others largely pull out of government bond markets they helped support — a process known as quantitative tightening — liquidity is drying up and causing instability in those increasingly fragile markets. This could keep large-scale government buyers in those markets longer than expected, complicating central banks' paths to achieving their monetary policy goals.
"We think there is a significant chance the Fed will have to pause or abandon quantitative tightening altogether once there are signs of systemic stress in the system as a result of its front-loaded policy tightening, which could jeopardize financial stability," said Anna Stupnytska, global macroeconomist at Fidelity International. "While timing is hard to predict, it may well happen earlier than markets and the Fed expects."
'Liquidity spiral'
The Fed started allowing maturing bonds to roll off its balance sheet in June. The Bank of England announced in September that it would begin to unwind its balance sheet later in the year, only for a pension fund meltdown to force the bank to start buying bonds again. Among the world's largest central banks, only the Bank of Japan is persisting with its loose monetary policy of low rates and asset purchases.
A slowdown in housing markets and retail spending may be the planned outcome for central banks trying to curb inflation through tighter monetary policy. Rate hikes and balance sheet reductions, however, are causing markets to wobble, with big banks less willing to serve as bond market makers and investors finding it more difficult to buy and sell as market depth evaporates.
"The Fed has to be very careful through this cycle not to basically cause another financial crisis by trying to do too much too fast," said Patrick Leary, a senior trader with Loop Capital Markets.
In the Treasurys market, much of the liquidity decline is due to the Federal Reserve's decisions to stop buying hundreds of billions of dollars of bonds every month and to reduce its roughly $9 trillion balance sheet. Meanwhile, requirements such as the supplementary leverage ratio, which sets capital requirements, and other reporting rules have discouraged major financial institutions from being market makers in the Treasurys market.
As liquidity worsens and quantitative tightening continues, cracks have begun to emerge throughout the global financial system. Those cracks could be far more severe as the Fed and other central banks continue their aggressive monetary policy shift at a time when market liquidity is particularly poor.
"There is a liquidity spiral issue that you have to worry about," said Richard Farr, chief market strategist at Merion Capital.
Bank of England saves gilt market
In late September, the Bank of England was forced to intervene to stop a "death spiral" in the gilt market. At the heart of the crisis was a prolonged sell-off by pension funds, typically one of the biggest sources of demand for gilts.
Defined benefit pension funds need to match their liabilities with assets. In the past that was done safely enough by buying long-dated government debt, as the yield on offer would cover the liabilities — pension payments. But years of low yields on government bonds left pension funds with big deficits, so fund managers used leverage to increase the returns generated from the low yields.
This was done through derivatives, using a government bond as collateral to buy more government bonds. The system worked well until the recent fall in global bond prices, as central banks started raising interest rates to tackle inflation.
The pension funds were issued with margin calls, forcing them to post more collateral to back the derivative contract. This instigated a sell-off of the pension funds' most liquid assets — government bonds — to raise capital. The sudden surge in the supply of bonds hit an illiquid market with few buyers, pushing prices down further and triggering more margin calls. The situation was amplified by a poorly received economic plan from the government that included unfunded tax cuts.
The Bank of England's £65 billion intervention eventually brought stability. The move was reminiscent of March 2020 turmoil in the Treasury market, when liquidity vanished in the deepest capital markets in the world, forcing the Federal Reserve to start buying $120 billion of bonds each month to restore stability.
While liquidity has not disappeared as dramatically elsewhere yet, warning signals are flashing.
The spread between bids and offers in the U.S. government bond market has widened while the depth of the market has shrunk, with market players finding it increasingly difficult to unload some larger amounts of Treasurys, according to Leary.
Throughout October, the ICE BofAML MOVE Index, which tracks the price movements of options on a basket of Treasurys to measure volatility in the government bond market, settled near highs not seen since the early days of the pandemic, with the potential to hit levels last reached in 2009.
Meanwhile, in Europe, asset-swap spreads of short-dated, high-quality euro securities have widened sharply. In an Oct. 25 open letter to the European Central Bank, lobbying group International Capital Market Association warned that dislocations in the eurozone repurchase agreement and money markets are increasingly likely as the bank tightens policy.
'A useful pressure valve'
Federal financial regulators are working on a series of reforms aimed at helping the government bond market to "absorb shocks and disruptions, rather than to amplify them," Treasury Secretary Janet Yellen said in an Oct. 24 speech.
The Fed has another tool it could lean on in the case of illiquidity causing markets to malfunction; the International Capital Market Association has labeled it a "useful pressure valve" and has called on the European Central Bank to adopt a similar program.
In the U.S., banks are required to hold collateral against their liabilities, which typically means holding Treasurys. Quantitative easing — the Fed's asset purchase plan — pulled Treasurys from financial markets while injecting banks with trillions of dollars in cash.
Through a program known as the overnight reverse repurchase facility, the Fed essentially set up short-term loans by selling securities to banks — aiding them in meeting their collateral requirements — and buying them at a higher price the next day. The Fed pays an overnight interest rate of 3.05% to incentivize cash to be parked in the facility rather than in bonds where the demand would push down yields, easing monetary conditions when the Fed wants to tighten.
This program has been used extensively, with $2.187 trillion flowing in on Oct. 26. Were the Fed to reduce the interest rate on offer, the cash would likely be redirected into the Treasury market.
"What quantitative tightening is ... doing is tightening liquidity circumstances, but slowly," said Padhraic Garvey, regional head of research Americas at ING. "In the U.S. there is certainly some way to go before liquidity is not dominating collateral."