Politicians and economic commentators are obsessing about the view that the cost of UK government borrowing is increasing as a consequence of the war in Iran. This is the relevant chart, reproduced from the Financial Times at around 10 am this morning, and it shows that the current borrowing cost on 10-year gilts is, supposedly, 4.99%.
Let us be clear about this: there is no reason at all for this borrowing cost to be that high.
As a matter of fact, the UK government cannot default on its debts, so why the supposed risk of depositing funds with the UK government, which is all that we are talking about here, should vary significantly as a consequence of the war in Iran is almost impossible to work out, when this will always ultimately be the safest place to deposit sterling.
There is, however, one obvious response to this situation which the UK government should be taking, but which it clearly is not. When the world wishes to sell UK government bonds, at what must be an undervalue, because that is why the interest rate appears to be so high, the job of the UK government is to buy them in whatever quantity is required until the point is reached where the UK government has achieved the interest rate that it desires, which will be one way lower than 4.99%.
And let us not pretend that the UK government has not got the capacity to do this. When the UK government chooses to buy government bonds, all it does is an asset swap. It replaces bonds in the market, on which it pays an interest rate of 4.99%, with cash in the central bank reserve accounts, on which at present it is paying 3.75%. It is grossly irresponsible for it not to take this action at present, because it is imposing a cost upon us all which is utterly unnecessary.
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Sadly I don’t imagine this will be an option this morning’s COBRA meeting will be discussing with the governor of the BofE this morning – expect more warning of interest rates having to go up!
Hi Richard,
An alternative to 10y gilt asset purchases would be for the DMO to just not issue new gilts with the longer maturities and instead supply at the short end where there’s clearly more demand (likely due to increased uncertainty).
But yes, far better to at the very least eeadopt a tap system for debt management where the yield curve is fixed with quantity of gilts floating for each duration, leaving any shortfall as sterling reserves earning, preferably, 0%.
Wrong. There is an absolute gain to be had by buying 10 year bond. This is interest rate arbitrage and the government could do it.
Yes, I agree, but only assuming that the extant 10y gilt has a coupon yield greater than the current bank rate which is not the case for most of them given the 2022 Base rate hike.
If a 10 y gilt was issued in 2020 with a coupon of ~0.1% on face value, the state continues to pay that tiny interest flow on it. Buying that and replacing it with a floating 3.75% reserve balance would obviously *increase* overall interest expenditure.
In that case, better to keep that existing interest promise and just swap all higher-than-current-bank-rate outstanding fixed rate sterling liabilities back for sterling reserves earning 3.75% (could be cut to zero ofc).
You are ignoring the discount involved. Why?
“This is interest rate arbitrage and the government could do it.”
It is absolutely not arbitrage as there are different duration and there for different risk. Arbitrage is risk free profit and this simply isn’t . Clive Parry will endorse this 100%.
You are wrong, because you are assuming that the guilt acquired cannot be sold again. Elementary mistake.
In reply to Craig (and you). “Arbitrage” means making risk free profit….. so, no, just as it is not a risk free trade if I were to buy a 10 year gilt at 5% (financing the position in the Repo market at Base Rate), neither is it for the BoE. Indeed, that was what QE was all about…. except it was conducted at 1% not 5% yield…. and “lost” a lot of money.
However, the BoE actually controls Base Rate so could ensure it makes a profit by not hiking the Base rate. Of course, this does make it difficult for the BoE to hike rates if required because of the losses it would incur on its portfolio. That was the case with the Fed in the 1960s – but that doesn’t really count as the USD was on the Gold Standard.
Thinking in P+L terms and arbitrage here misses the point. The aim is to deliver a yield curve that is appropriate for the real economy……to that end, see the stand alone comment I made below.
@Clive,
Interesting discussion
You say “Of course, this does make it difficult for the BoE to hike rates if required because of the losses it would incur on its portfolio.”.
Well, yes, if the BoE holds on to the bonds then it would make a paper loss if it sold them again. But several points arise.
Really it doesn’t make sense for the Bank to hold the bonds. They are, indirectly, owned by the government and it makes no sense to hold a liability to yourself. Richard has argued several times that gilts held by the Bank should not be included in the national debt. In my view gilts should be cancelled when they are bought by the Bank. That of course would require a deeper understanding by some at the BoE and also a change in the way that they are accounted.
However, it seems to me that the Chancellor could instruct the Bank to cancel gilts that they hold at any time and this would have no immediate substantive effect. Of course cancelling bonds would prevent the Bank reselling them at a later date (QT) which, IMO, is a good thing. IMO too much undemocratic control of the economy is ceded by allowing the Bank to conduct QT. If bond sales are desirable they can always be conducted by issuing new bonds.
I suppose the question arises of who should by the bonds. If the Bank buys them we end up in the mess described above. So, perhaps, the Treasury should buy them directly. Then the question of whether they should be cancelled is resolved – a debt is cleared when bought back by its owner. If the treasury buys bonds directly they should clearly be cancelled. If this happened then the result would be that the government had a bigger “overdraft” with the Bank that it owns. As I argued previously this would have no substantive effect (and could be written off at any time).
@ Tim Kent
When I said “Of course, this does make it difficult for the BoE to hike rates if required because of the losses it would incur on its portfolio.”…. it was in response discussions about profits and losses. My main point was that this not about who makes or loses money it is about the BoE delivering good monetary policy – the right rates across the yield curve.
I entirely agree that bonds held by the BoE are “costless” as both BoE and HMT are part of government….. but I would stick with the current system. It requires no change in legislation…. just the mindset of the BoE. I would also add that monetary policy conduct should be delivered by one body (the BoE) so they should be the ones buying/selling gilts according to their policy aims.
Thanks for posting this. It needs to be said, and often. I entirely agree.
I find it is helpful to look in a little more depth, perhaps others do too.
The consequence of buying back bonds is that the government’s overdraft with the Bank of England increases by the amount spent buying the bonds. For some politicians this seems “bad” because the government then has a large “overdraft”. Actually it is neither good nor bad. The size of the overdraft has no substantive effect. That’s because the government “owes” the money to itself because it owns the bank. Any interest paid to the Bank is simply returned back to its owner the government. Any government debt (to the Bank) can be written of, at any time, with no substantive effect. The debt is merely the difference between what the government has spent, in this case buying back bonds, and what it has received in tax and through previous bond sales. Although it’s largely meaningless it makes some (most) politicians anxious because they don’t understand. 🙂 That’s why I think that government debt is misnamed and, as a consequence, leads to poor policy decisions.
What happens to the bonds when the government has bought them? Previously, QE, (the Bank) has held on to them, which make no rational sense. What is the point in the government owning (through the Bank) it’s own debt? The problem is that confused soles at the Bank then think they have to, later, sell those bonds back to the market, which sucks money out of the economy and depressed it. Bonds bought by the Bank, or the government directly, should, logically, be cancelled.
Another aspect is that the money paid to bond holders has to go somewhere and, as you say, it ends up in central government reserves where the government pays 3.75% . The money has to end up there since there is nowhere else for it to go. It is regressive that the government pays so much interest to the banks and their shareholders for those reserves. They did nothing to create them. So, to me, this highlights the need to tax the wealthy to reduce the level of reserves.
Just to check my understanding, the UK government isn’t actually paying an interest rate of 4.99% on existing bonds – that’s just the internal rate of return to solve price now vs coupons plus redemption? But new bonds might need to be issued a rate comparable with the prevailing yields?
Correct, broadly speaking
Ok so what is then confusing is me is the reference in your article: “It replaces bonds in the market, on which it pays an interest rate of 4.99%”.
It can buy them 8n and the effective rate on them is 4.99% at the price they pay.
Ok so it might be fair to describe this as the government swapping cash, on which it is earning 3.75% p.a., for bonds on which it can earn 4.99% p.a. (if held to redemption)? As yields fall, the price goes up and it can then sell it back to the market and make a gain. (And any investor could do that in principle, just not at the scale that the government could, and with risk attached that the government is essentially immune to.)
The markets are extremely volatile at the minute, changing with every media post from the maniacal Trump. I leave the interpretations of these gyrations to those who play the markets ( gambling in my book). Serious investors will just be watching.
Movements in interest rates, we hope, chart a much longer course than this, but there is no doubt they are too high whatever the markets are doing. As you say, our gov can, with sound economic reasons, decide what interest it is prepared to pay and ignore the wild gyrations of a casino stockmarket.
I was listening to the BBC this morning and hearing that the government’s cost of borrowing had risen. This is totally wrong. The rate is set when the bond is issued and the price when it matured is also fixed. What is happening is that the market price is lower than the issue price so the rate against this price is higher. You are correct that this is the time for the government to buy and cancel the bonds. If I can work this out why can the BBC not.
Thanks
There seems to be utter confusion at the BBC and elsewhere in the media about what Government debt actually is; the BoE base rate is and what it does; the role of the Debt Management Office and how it sets rates for bonds, and the fluctuations in rates on the second-hand bond market and how these fluctuations relate to the duration of the bonds being traded as well as economic factors like fears of inflation. And because the BBC doesn’t understand each aspect, it also can’t get a grip on the extent to which they do and don’t interrelate. Having said that, I’m not too clear about it myself! It is complicated. Probably more complicated than it really needs to be, as there’s nothing like a bit of mystique to keep a gravy train going. But I don’t set myself up as the World’s number one truth-teller like the BBC does. People listen to their rubbish and believe it.
It’s tricky stuff for the layperson to get their head around and the dumbness of the MSM over so many years certainly hasn’t helped. You might like to help out your National colleague Steph Brawn who seems just as confused as the BBC today:
https://www.thenational.scot/news/25958796.uk-government-borrowing-costs-hit-highest-level-since-2008/
I, too , am confused by the whole jargon of ‘ bonds and gilts’. Perhaps you could do a blog for financial dummies? Setting out in a step by step analysis of what it all means…..
Not the news…
Today in Tehran, Jerusalem, and the White House, war leaders considered the latest bulletin from the Bank of England before deciding to carry on killing people and endangering the planet.
Meanwhile in Threadneedle Street, the Governor kept the blinds down, and the TVs switched off, and followed the instructions in his “Monetarism for Dummies” handbook (published 1980).
(I temember when BoE rates and inflation were pushing towards the 20% decile – I hope he doesn’t get nostalgic for “the good old days” of the last big oil crisis.)
What we are trying to achieve is maintaining credit provision to the real economy at an appropriate rate. Everything else is a sideshow – eg all the nonsense of “cost of borrowing for government” etc. Real business is feeling the pinch in terms of higher energy costs so the last thing they need is higher interest costs. And if the BoE is worried about “second round effects of a wage/price spiral” then they really should step out along the Mile End Road. The truth is that the economy was struggling before the war kicked off
So, first and foremost we need a speech saying that hiking rates makes no sense when we see a supply side shock. Indeed, the shock may well mean that lower, rather than higher, rates are needed.
In the US, Fed Funds is at 3.75% – the same as UK base rate. September SOFR futures imply rate stay unchanged there. In the UK Sonia futures imply rate going up by 50 – 75bp. The US pricing seems reasonable, the UK prices for stupidity at the BoE.
Once we have tackled the expectations about where Base Rate is going we might well not need to intervene in the gilt market…. but we should if required.
Why do I push the importance of Base Rate over 10 year gilt yield? Well, that is where most business borrows – Base Rate plus a spread.
Thank you Clive – I could not agree more with your conclusions.
Further to your post (government should BUY bonds); and others’ comments (at least, not SELL new bonds); government is also selling new Treasury Bills, with 3-month and 6-month maturities. They have no ‘coupon’ but are sold with a discount, giving an effective yield. Sold by auction… the exact rules of which are unclear to me; but as I understand it, the level of demand or the level of the corresponding bids, with some spread, means that the government takes in money from the market at a rate which is mostly dictated by that market, subject only to the government refusing to deal (if the offers are too low) in which case government doesn’t ‘take any money in’.
Does the government really need to do this? (i.e. is it yet another manifestation of the myth that ‘government has to borrow from the market to balance its books’?)
Or is it simply a way to offer a short-term safe home for funds in the money market? (As per Richard’s comment about what gilts do for those with longer-term funds to put somewhere safe with a guaranteed return.) So in effect, it’s a sort of government guarantee of return of capital, similar to the government ‘guaranteed return of funds’ on retail savers’ bank deposits – but on a much larger scale, for institutions with large amounts.
In which case, why do they auction them and allow the market to set the rate of return via the discount? Why not just offer a short-dated gilt with a fixed coupon; or a t-bill with a fixed discount? Then those in the market with funds to put ‘somewhere’ could ‘take it or leave it’…
The whole gilts, t-bills and CBRA system seems fundamentally misunderstood, misused and misaligned with the reality of sovereign money creation… As if it’s deliberately set up to create a tool for financiers to control government, aided and abetted by the Treasury, ‘economists’, ‘government advisers’ and ‘think tanks’ (and to create myths, obfuscation and misunderstandings amongst us all, most notably those who should be in control, our democratic representatives and government!)
Might it help if the Debt Management Office was renamed? “National Investment Agency”?
Yes, if it was repurposed, as it should be.
Why issue T-bills? Well, they always have done, some investors really like them. Why no coupon? That is just the traditional way it’s done and the economics are completely equivalent to a coupon bond.
Yes, they are auctioned as “market rates” and large holders of cash (who are not clearing banks) will buy them at rates lower that the base rate as the only really safe place to invest. If the supply exceeds this demand then banks will always buy at yields slightly higher than the Base rate (that they earn on their cash otherwise) – this caps yields at roughly Base Rate plus 5bp. (o.o5%).
These bills are “cash like” and act a collateral in borrowing/lending operations, too. So, they are handy to have in the system.
My eyes cross and my head hurts when I try to understand bond swapping. However, I do wonder how interrelated are gilt bond rates, BoE base interest rates and property mortgage rates ? How many in the uniparty UK government are now in possession of ever lucrative rentier property portfolios ? Has the UK property investment Ponzi scheme become too big to fail ? Is it now slowly choking the real economy to death ?
Richard says “When the world wishes to sell UK government bonds, …the job of the UK government is to buy them in whatever quantity is required until the point is reached where the UK government has achieved the interest rate that it desires.”
According to Times Radio business presenter Dominic O’Connell (in an article in the Times on 24/3/26) that is exactly what the Japanese government has been doing.
He says “The Bank of Japan has persistently intervened in the markets, buying and selling Japanese government to keep rates low”. He also says, if I understand correctly, that the Japanese Ten Year bond yield was less than 1% for some years and did rise but only to 2.24% while the corresponding figure for the US was 4.35 and for the UK 4.25%.