One of the primary mandates for the Bank of England is to manage the stability of financial markets.

At the end of September, the UK central bank enacted a ‘gilt market operation’ to buy long dated UK government bonds. The Bank announced that it will make ‘temporary purchases of long-dated UK government bonds’ to tackle the dysfunction in the market.

The Bank said: ‘Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability. This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy.’

It’s hoped that the Bank’s move will stop UK borrowing costs rising higher, lessen calls for emergency interest rate increases and bring some calm to the markets.

Why did the bank step in?

UK government borrowing costs, as measured by gilt yields, rose following Chancellor Kwasi Kwarteng’s Mini-Budget, which included a proposal of tax cuts (subsequently withdrawn) and a cap on energy prices. This caused panic in the market as investors worried about how the government would fund these proposals. Events fed through to UK consumers in the form of issues in mortgage markets, with banks and building societies pulling home loans and increasing rates, as they faced volatility in the money markets that they use to fund home loans.

Reports also emerged of pension funds being put under pressure. Defined benefit pension schemes invest in particular types of assets that help to protect against changes in interest rates. The pricing of these assets is linked to gilt prices and so the sell off in gilts led to some pension funds selling off assets. It is understood that, had the bank not stepped in, some pension funds would have been under serious stress.

Although the central bank refrained from an emergency rate hike to offset the slide of the pound in FX markets, it has now intervened in the bond market. Yields have dropped in response to the initiation of the programme, with a flattening of the yield curve and long-dated bonds rallying, however, volatility has remained.

What has been enacted by the Bank of England?

In what came in as a surprise to investors, the Bank announced a temporary programme of bond purchases to stabilise the market, buying up long-dated gilts from the 28th of September.

Government bonds are issued by countries as a way of financing their economy. They are issued over different lengths of time and pay investors a set rate of interest (a coupon) as well as the bond’s starting value at the end of the term (it’s maturity).

Bond yields measure the interest rate return an investor would get for buying a bond at the price it is trading at. If a bond’s price falls, its yield rises as investors are purchasing a set amount of interest at a lower price. Rising bond yields on the secondary market have an impact on new debt that is issued, as unless new bonds match the returns on second-hand bonds investors may choose not to buy them.

By becoming a big buyer of UK government bonds, the Bank increases demand in the market which has the effect of driving up the price of gilts. Bond yields and prices move in opposite directions, so when you push up the price of the gilts it pushes down their yields.

Gilt yields not only matter for the cost of UK borrowing but also have an impact on the mortgage funding market. The Bank will hope that this action also brings some stability here.

What’s next for the programme?

Earlier this week, the head of the Bank of England surprised markets by announcing that the emergency programme will be finishing by the end of the week. This led to renewed volatility in Gilt yields as investors were losing a ‘buyer of last resort’ in the marketplace.

What is very confusing for investors and something that markets are struggling to price in, is whether they will be able to stop the purchase programme on the 14th.

What is clear, is that the Bank of England is still in a battle with the newly formed Conservative Government, with both parties reluctant to give up on their stated mandates. The Government is pushing for growth through spending, whilst the Bank of England is looking to tame inflation by decreasing spending in the economy. These two sets of policies are opposites and will lead to both sides having to re-evaluate the actions they take moving forward. Already, the government and Bank of England have had to partially divert away from their initial plans, and we believe this will continue.

Whilst this is still the case, volatility will be present, especially in the Gilt market. This will feed through to other assets classes, with differing degrees of impact depending on the underlying asset. We are cognitive of the risks and opportunities that are currently present in all investments, not just in the UK but globally as well. As long-term investors, we have positioned our portfolios to aim to provide a degree of protection in downwards markets, but to be able to benefit from the recovery as and when that occurs.