This article by Jeremy Warner begins with these words "Higher public debt costs are coming as rates rise".
With rising inflation and interest rates, there have been some big losses in government bond markets over the last two months, confirming the old truism that even when it comes to government debt, there is no such thing as a “risk free asset” – much as HM Treasury might want you to believe otherwise.
Since the middle of December, for instance, the price of a 10-year UK gilt has fallen by nearly 8pc, more than doubling the effective yield on the security to 1.5pc.
That may not seem much of a loss by the standards of equity markets, where volatility of this magnitude is relatively common, but for government bonds it is a major move, and quite a shock to pension funds required by regulatory dictat to match burgeoning liabilities with assets which are supposedly completely bullet proof - by which regulators mean mainly top rated government bonds.
One of those looking on with a growing sense of panic will be the Chancellor, Rishi Sunak, and not just because the effect of falling gilt prices is to greatly increase the costs and challenges of financing the deficit on government spending.
What it also does is dramatically increase the losses likely to be sustained on the Bank of England’s £895bn stockpile of government debt, built up over more than 10 years of so-called “quantitative easing”.
The resulting liability was mentioned in a little noticed exchange of letters between Sunak and Andrew Bailey, Governor of the Bank of England, published at the same time as the Bank’s latest Monetary Policy Committee report just over a week ago.
In the exchange, Bailey pointedly reminded the Chancellor that “reverse payments from the Government were likely to be needed in the future” on the Bank’s holding of gilts, and that these should “be met by the Government on a timely basis.”
Sunak had no option but to promise that “any potential future cash shortfalls will be met in full.” The issue has arisen because in attempting to stimulate the economy by depressing interest rates, the Bank paid more for much of its holding of gilts than it is now worth. With “quantitative tightening”, big losses become inevitable.
A quick back of the envelope calculation reveals that if all the gilts in the Bank of England’s asset purchase facility (APF) were sold back to the market, it would at current prices incur a loss of more than £100bn, which would then have to be reimbursed by the Government.
As it is, the Bank of England has put the Treasury on notice that it intends to start unwinding QE via a process of natural run-off, or simply not reinvesting the proceeds as the gilts reach maturity.
The first such reduction in the stockpile will accordingly take place in March 2022, when £27.9bn of APF-owned gilts are due to mature.
The likely loss will be in the region of £3bn, which the Treasury is obliged to reimburse under an indemnity agreed by George Osborne, then Chancellor, when the jiggery pokery of QE began shortly after the financial crisis.
The Bank has also flagged its intention of beginning outright sales of gilts once Bank rate reaches 1pc, which will be sooner rather than later, given the way inflation is going.
Frequently depicted as money printing - which to my mind is reasonable enough shorthand - QE is more precisely defined as a form of interest rate swap.
By buying up Government gilts, the Bank of England is replacing long dated debt, which would typically command a coupon of around 3pc, with a short dated asset that pays Bank Rate, which ever since the financial crisis has been close to zero.
So in the money merry go round that was devised, the Treasury pays the promised coupon on the debt to the Bank’s APF, but the Bank shells out only Bank Rate on the reserves held by commercial banks - effectively cash - in lieu of the gilts they once owned but have now sold.
Any resulting surplus in the APF is then paid back to the Government.
Ever since this funny money scheme was first concocted, the transfers have been extremely helpful to the public finances, contributing a grand total of nearly £120bn to the exchequer by the end of last year, according to the Office for National Statistics. This is worth around 2p in the pound off income tax in terms of the money raised over the same period.
But all good wheezes eventually get found out and come to an end, and that’s precisely what threatens to happen as interest rates go higher. The first hit comes from a rising Bank rate, which means that the benefit the Government derives from paying next to nothing on its debt rather than the original coupon, erodes.
If Bank Rate goes above the aggregate coupon rate, then the flow of money between the Bank of England and the Treasury reverses completely.
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Governor of the Bank of England - Andrew Bailey