Following Brexit, the Bank of England (BoE) had waited a few weeks for economic data to indicate whether they should take action. When data pointed to weakness, they decisively unveiled a host of financial packages to stimulate the economy. Whether the packages actually work is a different issue altogether.
One of the measures of the package was expanding the BoE’s quantitative-easing program, which included the purchase of up to £10 billion of UK corporate bonds and also the expansion of the asset purchase scheme for UK government bonds of £60 billion (According to the Bank of England).
But, the BoE’s quantitative easing program hit a roadblock on just its second day in operation, as the central bank struggled to find enough bonds available for purchase—even though it was offering substantially higher rates than the market.
The theory behind the decision to buy bonds is a classic monetary policy move: as the central bank buys bonds worth billions of pounds, it pushes up the price of bonds and simultaneously lowers yields. Lower bond yields mean more favorable rates on loans, which should spur borrowing and investments. Additionally, lower yields should nudge investors towards riskier asset classes and ventures, freeing up additional capital to fuel the economy.
However, as the BoE tried to apply this theory in practice, the execution failed considerably, owing to pension funds’ reluctance to sell their bonds. This isn’t a new problem for the BoE, either. In 2009, when the central bank starting buying government bonds to boost UK’s economy, it also failed to garner enough willing sellers to meet its purchase target on a few occasions. In the current case, investors offered to sell just £1.12 billion worth of gilts with maturities over 15 years, compared to the BoE’s set target of buying £1.17 billion worth of them—meaning they had more than a £50 million shortfall from their goal (According to Reuters).
One of the main reasons for pension funds’ lack of enthusiasm to sell UK gilts is the unwillingness of the bond holders to part with long-term return offered by the bonds. In a very low rate environment, it makes sense why they’d want to hang onto their bonds, especially since they have payments due to pensioners and participants in their fund. If they sell to the central bank, they also risk losing some of the yield they need to avoid deficits and make sure they remain above water.
When it was all said and done, the BoE shortfall instigated another downward rally for UK government debt. The short-dated yields moved into negative territory, while 10-and 30-year benchmark yields fell further to all-time lows. Yields on 10-year gilts fell below 0.6% for the first time in history, marking a record-low of 0.532% (According to Investing.com).
Bottom Line for Investors
The BoE defended the shortfall by saying that August months are generally thin trading ones, and that the summer season means many decision-makers in asset management firms may be on holiday. They expressed confidence they’d make up for the shortfall in the second half of the six-month buying period.
But a shortfall just on the second day of the new program is a big hit to confidence about the program in general, and it underscores problems the central bank may face going forward. For now, we believe it’s too early to cry wolf on the BoE’s planned stimulus, but we can attest to the modest—if not questionable—benefit of QE programs. Lower longer term bond yields also mean flatter yield curves, which squeezes the net interest margins at banks, discouraging them to lend. It seems it may be time for governments to start looking towards fiscal spending if they want to make a direct impact.
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