The Bank of England announced on Wednesday that it would temporarily step in to purchase long-dated bonds to tamp down disorderly market conditions that have prevailed since the Truss government announced its plan to cut taxes.
Financial conditions are tightening noticeably as credit spreads widen, all of which will constrain overall economic activity.
The £45 billion ($50 billion) plan comes on top of the government’s £150 billion ($166 billion) plan to cap energy prices. Together, they have pushed the value of the pound lower, yields to increase and prompted a general outflow of capital.
Adding to the strain, the plans come at a time when productivity is weak and the domestic economy needs foreign investment.
The result has been a rising risk to financial stability, leading the Bank of England to announce its policy shift on Wednesday.
That policy incoherence has resulted in a decline in the RSM UK Financial Conditions Index to 2.5 standard deviations below neutral, which signals a significant degree of excess risk being priced into financial assets and implies a greater drag on overall economic activity.
Those conditions are best illustrated by a widening in the eurodollar spread to 130 basis points from 32 basis points last week.
Confusion reigns
The general policy confusion has roiled both domestic and global financial markets and is likely to cause sterling to fall below parity against the U.S. dollar in the near term and further increase the cost of doing business because of deteriorating credit conditions.
Financial conditions are tightening noticeably as credit spreads widen, all of which will constrain overall economic activity.
The policy mismatch is not sustainable. Either the Truss government will need to reverse course or the Bank of England will have to pull back on plans to reduce the scope of its intervention into financial markets and increase interest rates.
Financial market participants are pricing in a 150 basis-point hike at the central bank’s next policy meeting on Nov. 3.
Money markets
The decline in financial conditions reflects increased levels of risk as the pound and corporate bonds decline in value. But most concerning is the increased cost of credit in the money markets, which will affect the day-to-day financing of commerce.
In our estimation, the fiscal or monetary authority will have no choice but to blink in the coming days.
While the yield on the 30-year gilt has retreated in the aftermath of the Bank of England’s announcement, sterling has further depreciated and is trading near 1.0571 against the dollar and .9035 against the euro.
Given the fact that the structure of the domestic mortgage market features floating two-year and five-year mortgages for most homeowners, the fiscal and monetary authorities will need to convene on a policy alignment that stabilizes the economy and prevents a disorderly downward spiral in the housing market.
