Wednesday, 25 February 2009

Gilts: bank liquidity + QE = bull flattening

Two recent developments imply bull flattening of the Gilt curve...

First, Morgan Stanley estimate that UK banks will be forced to buy up to £100 billion of Gilts in 2009, following the announcement of FSA’s new liquidity regime . This compares to a total Gilt market size of about £480 billion as at end-2008, and planned net Gilt issuance this financial year of about £130 billion.

Banks will be required to hold Liquid Asset Buffer portfolios, consisting of a combination of Gilt holdings stretching far out along the yield curve, with perhaps some of the duration risk hedged by interest rate swaps. Moreover, the steep Gilt curve gives a strong incentive to put more long-dated Gilts in the portfolio, despite their higher volatility.

Second, the MPC unanimously voted to seek authority to embark on quantitative easing (see February MPC minutes) in the form of buying government and other securities, financed by the creation of central bank money using the Asset Purchase Facility. The BoE believes that these measures are required in order to prevent CPI undershooting it's 2% target until 2012. The size of this QE program is rumoured to be £100-150 billion.

Both these developments imply bull flattening as a possible £250 billion of Gilts are purchased, forcing a compression in longer dated yields. Moreover, this is more than enough to soak up all of the expected £130 billion issuance for the current financial year.

Some links to articles demonstrating the above:


  1. FT article supporting bank demand for government bonds...

    2 Mar 2009 5:01pm
    Banks raise government debt holdings

    Eurozone banks have sharply increased their holdings of government debt in a sign of the deteriorating economic climate that has forced financial institutions to strengthen their balance sheets.

    Bank holdings of eurozone government bonds rose by €115bn ($144.9bn) between November 1 and the end of January – the biggest three-month rise since September 1997 – to stand at €1,299bn, according to European Central Bank data.

    This is the highest amount since February 2007, when banks were buying all kinds of securities in a booming market place.
    In January alone, holdings jumped by €58bn – the biggest monthly rise since November 2005. According to UBS, this means banks bought 75 per cent of the total €77bn of eurozone government bonds issued in January, much higher than usual.

    US and UK banks have also increased their government bond holdings in recent months, according to strategists, forcing down yields on sovereign debt to record lows as most institutions seek the safety of so-called risk-free assets in times of

    Analysts expect banks to continue buying government paper because of the increasingly gloomy outlook, easing worries of a possible sell-off in sovereign bonds. Some bankers had warned that a bubble was building in these markets.

    As well as the need for high-quality securities to boost balance sheets, analysts believe the banks are under pressure from governments to buy sovereign bonds to soak up record levels of debt that has been issued to pay for economic stimulus packages and bank bail-outs.

    This pressure may be greatest in countries that have been hardest hit by the financial crisis as these governments have by and large had greater difficulties attracting other investors, worried about the state of their economies.

    This would explain why banks in countries such as Spain and Ireland have increased their holdings of government debt relatively more than peers in other eurozone countries. Spain's credit ratings were cut in January, while Ireland has been warned that its ratings are vulnerable to a downgrade.

    A crackdown by the ECB over the type of securities that can be used to obtain central bank funds may also have encouraged banks to increase their government bond holdings.

    The ECB raised the cost of using asset-backed securities in exchange for cash or high-quality bonds, such as US Treasuries, in September. It also announced in January that it would tighten the rules further in March.

    Spanish banks, which analysts believe were offering large quantities of asset-backed securities as collateral before the crackdown, have increased their holdings of government bonds by €30bn since September – more than any other eurozone country.

    Meyrick Chapman, fixed income strategist at UBS, said: "Some banks may have engaged in a swap with their governments of non-performing assets, such as asset backed securities, for better quality government bonds.

    "A country facing difficulties financing itself would also probably seek to use its banking system as a buyer."

  2. 5th March 12:00 BoE cuts rates and confirms QE programme in the statement...

    "The Bank of England’s Monetary Policy Committee today voted to reduce the official Bank Rate paid on commercial bank reserves by 0.5 percentage points to 0.5%, and to undertake a programme of asset purchases of £75 billion financed by the issuance of central bank reserves...

    ...The Committee judged that this reduction in Bank Rate would by itself still leave a substantial risk of undershooting the 2% CPI inflation target in the medium term. Accordingly, the Committee also resolved to undertake further monetary actions, with the aim of boosting the supply of money and credit and thus raising the rate of growth of nominal spending to a level consistent with meeting the inflation target in the medium term.

    To that end, and noting the recent exchange of letters between the Governor and the Chancellor of the Exchequer concerning the use of the Asset Purchase Facility for monetary policy purposes, the Committee agreed that the Bank should, in the first instance, finance £75 billion of asset purchases by the issuance of central bank reserves. The Committee recognised that it might take up to three months to carry out this programme of purchases. Part of that sum would finance the Bank of England’s programme of private sector asset purchases through the Asset Purchase Facility, intended to improve the functioning of corporate credit markets. But in order to meet the Committee’s objective of total purchases of £75 billion, the Bank would also buy medium- and long-maturity conventional gilts in the secondary market. It is likely that the majority of the overall purchases by value over the next three months will be of gilts.

    At its future meetings, the Committee will monitor the effectiveness of this purchase programme in boosting the supply of money and credit and in due course raising the rate of growth of nominal spending, adjusting the speed and scale of purchases as appropriate."